Turkey crisis impacts India

The Turkish Lira has dropped almost 30 per cent in the last month. The Indian rupee, too, has fallen to pass Rs 70 to the US dollar for the first time. Does the Turkish crisis pose a significant threat for India? 

No and yes. It is unlikely that the crisis in Turkey will affect India beyond the short-term. But yes, a crisis similar to this could easily strike India at some point in the future. Strengthening the rupee, to preserve India’s future economic growth, should be high priority for the Reserve Bank of India. 

In global financial markets, bad news travels fast, resulting in collateral damage beyond its immediate point of impact. The 2008 global financial crisis started in the US, but spread globally as a result of complex interrelated financial instruments. This is called a financial ‘contagion’ and it stems from the collected response of investors to avoid risk and move to safer investments. This is akin to swimmers wanting to swim to the shore when the sea starts to get rough. 

Turkey’s crisis will impact countries like India because these two countries get clubbed together as emerging countries in most investment models. So, when investors start dumping Liras, the rupee gets swept along in the selling. A falling Lira increases the risk of bankruptcies as Turkish companies (and the government) would have a harder time paying back their foreign-currency denominated loans. This puts a shadow on other emerging countries like India which also have substantial dollar-denominated debt.    

India’s external debt on March 2018 was $530 billion or about 21 per cent of GDP, more than two and a half times that of Turkey. Overseas borrowing for Indian companies and the government has increased dramatically over the last two years, in response to higher domestic interest rates and tightening liquidity from the banking crisis. A drop in the rupee increases both the interest cost of this borrowing and the residual principal. So, a ten per cent drop in the rupee increases interest payments and the value of the unpaid principal by ten per cent. This is a substantial cost. What makes the decline in the rupee even more problematic is that 42 per cent of India’s foreign debt is short-term. Repaying back this loan with a depreciated rupee would severely impact the balance sheets of Indian borrowers. That is the short-term cost of the Lira crisis for India.

Turkey’s economic woes, however, appear unique and it is unlikely that the contagion would affect the Indian economy in the long-term. The Indian economy is triple the size of the Turkish economy and its current account deficit (as a per cent of GDP) is only one-third that of Turkey’s. Plus, India holds almost $400 billion in foreign reserves, thanks to repatriations by a large expat community. The most likely scenario is for a short-term drop in the rupee as investors flea to the safety of greenbacks (dollars), but the long-term effects to the Indian economy will likely be contained. 

But there are lessons to be learnt from this crisis. 

Firstly, Turkey’s problems stem primarily from uncontrolled inflation, which is currently running at around 16 per cent a year. The Turkish government has been stubbornly unwilling to raise interest rates to fight inflation. India is lucky that in 2013, the RBI, under then-governor Raghuram Rajan, made inflation targeting its primary policy objective. In 2016-17, Rajan received a lot of flak from economists and government officials over his unwillingness to lower interest rates to boost growth. But his hawkish stance on fighting inflation proved to be the right strategy. The RBI would be wise not to lose focus on inflation targeting, despite calls for lowering interest rates.

Secondly, the Turkish government has been spending more than it can afford, to keep the economy growing — the good old debt problem. Mr Recep Tayyip Erdogan, the Turkish President, has been busy handing out money like it was candy to stay in power. Indian politicians from all parties need to be mindful, especially in an election year, of splurging public fund on tall promises to special interest groups. Keeping India’s fiscal deficit down and reducing its foreign debt is a necessary condition for future growth.  

Thirdly, the Turkish government habitually interferes in the economy and attempts to pick winners and losers. This has resulted in a massive misallocation of capital in the economy, which eventually affects production at an aggregate level. The government creates priority sectors, but they are shunned by the market and the eventual result is failed companies and bad loans. Sound familiar? It should, because India faces a similar situation, both with the level of government involvement in the economy, and a state-run banking system burdened by a severe non-payable loan problem. The economy is a complex ecosystem with millions of stakeholders, each with their information and preferences. It is impossible for any government to efficiently manage such a system. The economy does best when it is left to the devices of a free market.

Fourthly, the RBI needs to strengthen the rupee for the long haul. It could do this by tightening the availability of rupee through open market purchases. But this would further increase funding costs for domestic banks at a time when they are already reeling from three straight quarters of operating losses. Another alternative would be to raise interest rates, but this would come at the cost of economic growth. Such a move is unlikely to be acceptable to the ruling party nine months before an election. 

Hence, the RBI’s best bet to strengthen the rupee is to eliminate restrictions on full convertibility of the rupee and make it a fully convertible currency. Restrictions on full capital convertibility have put a significant risk premium on the rupee. Removing these restrictions would eliminate this risk premium and strengthen the currency. 

Financial markets respond to expectations and sending the right signal at the right time is critical. Making the rupee a fully and freely convertible currency would send a strong signal to foreign investors that the currency is undervalued and that India’s macroeconomy is in a sound position to weather the risks associated with any capital flight. 

Actions speak louder than words, and by removing all restrictions on the free exchange of the rupee, the RBI can reassure foreign investors, and reverse the decline in the rupee. It is vitally important that this contagion be stopped in its tracks. 

The author is the founder, contractwithindia.com. Views expressed are personal.