Enough has been written about the recent crash of the Indian Rupee. This article does not intend to rehash any ‘predictions’ by the ‘experts’. Economic forecasting has often been compared to astrology, and justifiably so. As Nassim Nicholas Taleb says in his book, The Black Swan, “Forecasting by bureaucrats tends to be used for anxiety relief rather than for adequate policy making.”
Undoubtedly, the Indian rupee’s wild gyrations are due to hot money flows. The mere announcement of the possibility of the Fed’s Quantitative Easing program being tapered sent the rupee into a tailspin to test 68 levels. Then, the supposed postponement of the tapering program and RBI intervention gave some much needed respite, bringing it back to 61 levels. Ah, Mr Market with its manic depressive and euphoric bipolar disorder!
We analyse the situation using The Theory of ‘Reflexivity’ propounded by the legendary speculator, George Soros.
WHAT IS REFLEXIVITY?
Reflexivity refers to circular relationships between cause and effect. In Economics reflexivity refers to the self-reinforcing effect of market sentiment, whereby rising prices attract buyers whose actions drive prices higher still until the process becomes unsustainable and the same process operates in reverse leading to a catastrophic collapse in prices.
It is an instance of a feedback loop.
Reflexivity asserts that prices do in fact influence the fundamentals and that these newly-influenced set of fundamentals then proceed to change expectations, thus influencing prices; the process continues in a self-reinforcing pattern. Because the pattern is self-reinforcing, markets tend towards disequilibrium. Sooner or later they reach a point where the sentiment is reversed and negative expectations become self-reinforcing in the downward direction, thereby explaining the familiar pattern of boom and bust cycles
WHAT DOES IT MEAN FOR THE INDIAN ECONOMY AND RUPEE?
When a currency crashes, that itself changes the economy’s fundamentals. Domestic purchasing power reduces. Prices increase, negating the positive effects on exports. Corporations that have borrowed abroad suffer. Banks that have lent to such borrowers cannot recover their loans. International rating agencies downgrade such economies, inducing further capital flight.
India’s fundamentals have already changed. GDP growth in the first quarter is down to 4.4%. A slowing economy will help reduce the current account deficit, but hit the fiscal deficit. Wholesale prices had been falling but are increasing again, reducing purchasing power. All industries face slowing revenues and rising costs, decreasing profits.
Finance ministry analysts say the equilibrium exchange rate is Rs 58-60 per dollar. Similar things were said when Asian currencies began to slide in 1997. Far from recovering, they crashed further. The Indonesian rupiah went from 2,500 per dollar all the way to 18,000.
Raghuram Rajan has forecasted the Current Account deficit at $70 BN for FY 14 and thinks we may have to finance the deficit from our reserves (possibly a drawdown of $10 to 15 BN). Our FM thinks we are going to end up a with CAD number of $48 BN, more than adequately financed by capital inflows and our FX reserves should increase by $20 BN by March 2014. Observe the incongruence?
The threat of a credit downgrade has become very real.
