THE result of headless-chicken financial markets or a canary in the coal mine? India is grappling with this question. On November 22nd the rupee fell to an all-time low against the dollar. The speed of the rout (see chart) has been scary for a place that was supposed to be largely insulated from the rich world’s troubles. It is 20 years since India had a balance-of-payments crisis and for a long time the talk has been about it becoming an economic superpower. But there lingers a memory of when it felt it was a financial hostage to the world, and this helps explain the whiff of panic now in the air. Mumbai’s financial types say that firms are scrambling to find dollars and that desperate euro-zone banks, which supply about half of India’s foreign loans, are cutting off credit lines.

That sense of fear strikes some as overdone. Jonathan Anderson, of UBS, a bank, has tagged the rupee a “drama queen”. India’s high inflation and chunky current-account deficit, financed by capital flows, mark it out from most of Asia. But neither attribute is new. Chetan Ahya, an economist at Morgan Stanley, thinks India has its problems, but that the weak rupee mainly reflects the trauma in global markets, which has caused capital flows to dry up. Hardest hit by global risk aversion are countries with external deficits. The currencies of other places with current-account gaps, such as South Africa and Turkey, have been walloped too.
To be sure, the rupee deserves a beating, given how India’s prospects have dimmed. “The currency markets have been late in reacting,” reckons Samiran Chakraborty, of Standard Chartered, another bank. “The Indian business community has been more negative than foreigners for some time,” adds Roopa Kudva, the boss of CRISIL, a ratings and research firm. India’s growth model has been to run a small current-account deficit, financed with high-quality capital inflows, such as foreign direct investment and equity purchases. As a poor country this makes sense: India should invest more than it saves. But bits of its approach look rickety.
For a start the current-account deficit is likely to overshoot projections of about 3% of GDP for 2011, if October’s trade figures are anything to go by. Exports slowed faster than imports, a chunk of which are non-discretionary commodities and oil. The investment climate has soured due to stubborn inflation, high interest rates and GDP growth that may dip below 7% in the coming quarter. Pessimism about the government’s appetite for reform has surely hurt India’s ability to attract capital. Neelkanth Mishra, a strategist at Credit Suisse and a longstanding bear on the economy, reckons the quality of capital coming in is falling too, with flightier and riskier debt rather than stickier equity investments.
The falling rupee, then, partly reflects India’s economic failings. But will a cheaper currency add to these problems or help solve them? It should eventually narrow the external deficit, by boosting exports and limiting imports. Still, a sharp fall in the currency can be deadly if a country has borrowed in other people’s money. India’s indebted government sells its rupee bonds to locals, mainly banks, not jittery foreigners. The trouble is that since India’s banks are forced to stuff themselves full of loans to the state, Indian firms have had to borrow abroad. Sanjeev Prasad at Kotak, a broker, says that the recent results season saw a host of firms booking losses as the value in rupees of their foreign debts rose. He worries about them being able to refinance these borrowings.
And a lower rupee will fan inflation, which is already at 9-10%. The Reserve Bank of India (RBI), India’s central bank, and the government have been praying that it will slow. But a rough rule of thumb is that a 10% depreciation adds 60-100 basis points to inflation, says Mr Chakraborty at Standard Chartered. That’s unhelpful.
For the authorities there are three possible responses. They have already done the first: easing the rules on foreign lending to India, to try to attract short-term funds. The second option would be to intervene in the currency markets by selling dollars and buying rupees. That might, though, complicate domestic policy, by tightening monetary conditions further. If the RBI bought banks’ rupees then those lenders would have fewer available to buy government bonds, further increasing the already high borrowing costs of the state. The RBI could try to offset this by buying government bonds directly, but that might in turn hamper its efforts to support the rupee.

And has India enough firepower? The country has $314 billion of reserves, largely thanks to the central bank intervening in the past to stop the rupee appreciating too much. But that cushion is not as big as it seems. Mr Mishra reckons foreign debts that must be repaid within a year now equal 48% of India’s reserves. Using a similar approach of deducting short-term debts from reserves, Mr Anderson reckons India’s net position has deteriorated. Compared with other countries it is only middlingly good (see chart) and the RBI may be nervous of using too much ammunition.
That leaves a third option: for the politicians to make tough choices. If it cut its fiscal deficit the state would probably lower the current-account deficit. And if reforms were sped up, growth might recover, inflation could fall and foreign investment would pick up. The priorities include freeing the supply chains that have caused high food prices and cutting the red tape that is choking industrial projects. So far the omens are not promising. On November 22nd, the first day of the winter sitting of India’s parliament was adjourned due to raucous behaviour. Sadly, the rupee is not the only drama queen around.