India on the verge of Crisis as Rupee recedes

India may face its worst financial crisis in decades if it fails to stem a slide in the rupee, leaving the Reserve Bank of India  with a difficult choice over how to make best use of its limited reserves to maintain the confidence of foreign investors.

The rupee, which has dropped 16 percent in the past four months, got a relief  last week after the world's big six central banks banded together to try to ease dollar funding strains, helping it to snap a four-week losing trend. But analysts widely expect the rupee, trading on Monday at 51.26 per dollar, to resume its slide.

Current state of Indian Rupee perpetually  depreciating  makes RBI intervention into market mandatory through its monetary policies & other instruments available to its discretion.If  RBI’s intervention  is too timid, it add to risks by averting  portfolio investors, which India relies on heavily to cover its imports tab Aggressive intervention would leave the central bank open to criticism that it is wasting precious money on problems that are beyond India's control anyhow, noteably Europe's debt crisis.

Unlike most of its Asian peers, India has recently been running large current account and fiscal deficits. That means it must attract sufficient foreign money -- namely U.S. dollars -- to close the gap, and a weaker home currency makes that costlier.This is a perennial problem for India. The current situation is so worrisome because India is grappling with big internal and external economic threats simultaneously. Growth is slowing. Inflation remains high. Political paralysis has stymied domestic reforms.

The RBI, the last line of defence against a currency meltdown, has cautiously begun to support the rupee, but its firepower may be more limited than its $300 billion in reserves would suggest.Beyond India's borders, Europe is the biggest worry. As its banks deleverage, investment money has flooded out of India's markets. If Europe's debt troubles deteriorate, India could be hit If Europe's crisis deepens, India's trade deficit would widen even more rapidly, and it would have even more trouble attracting foreign capital.Risk appetite will obviously collapse and gradually the currency crisis is likely to take the shape of a balance of payments crisis.

India's current account deficit swelled to $14.1 billion in its fiscal first quarter, nearly triple the previous quarter's tally. The full-year gap is expected to be around $54 billion.Its fiscal deficit hit $58.7 billion in the April-to-October period. The government in February projected a deficit equal to 4.6 percent of gross domestic product for the fiscal year ending in March 2012, although the finance minister said on Friday that it would be difficult to hit that target.

India relies heavily on portfolio inflows -- foreign purchases of shares and bonds -- as a means of covering its current account gap. Those flows are fickle.Foreign portfolio investors have sold a net $50 million worth of equities so far in 2011 , in sharp contrast to the $29 billion they invested in 2010, data from the Securities and Exchange Board of India's website showed. In November alone, foreign funds pulled $661 million out of Indian stocks.

The drop in portfolio inflows and the hefty current account and fiscal deficits have been a key factor behind the rupee's decline. A deputy governor said on Saturday that the central bank would use "all available instruments" to stem a downward spiral.

POSSIBLE REMEDIES

If the RBI decides to step in more aggressively, its manoeuvring room is more limited than its reserves tally would suggest.After covering the current account deficit, short-term debt and foreign investment flows, there would be less than $20 billion left over.

 RBI's immediate concern would be arresting the spread of currency woes into the money market.India's banking system already borrows more than $19 billion from the central bank to meet reserve requirements, so if the RBI moved to prop up the rupee, it would drain more liquidity out of an already tight market.Companies make quarterly advance tax payments around mid-December, which puts an added strain on liquidity.In addition, a glut of foreign currency convertible bonds, issued when the rupee was much higher, falls due in the first quarter. 

The bonds are too expensive at current levels to be converted into stock and the sharp depreciation of the rupee will leave issuers with a heavy redemption bill.

The central bank could boost liquidity by cutting the cash reserve ratio, the proportion of deposits banks must set aside with the central bank as cash. Talk of a cut has circulated in Indian markets in recent days, although some economists argue that such a move could stoke already hot inflation.This move can exacerbate the already hot inflation in Indian Economy.

Going back to 1991 crisis foreign exchange reserves went to near zero levels, India rapidly depleted its reserves, forcing a currency devaluation.Looking at the present state of India’s political & economic condition , the risk is that RBI will wait too long to act .