January 1998 and July 2013 – what is the difference?

Why did Reserve Bank of India’s measures in 1998 work? How do they compare with the current set of measures?

I had finished writing my last MINT column on Sunday and dispatched it on Monday morning.[1]  Then we heard that the Reserve Bank of India (RBI) had effectively hiked the interest rate to 10.25% on Monday, to prevent the rupee from weakening further. In the light of what my column had suggested, I felt that the RBI had done the right thing or the inevitable thing. In this case, both converge. Not all of us could go and live happily ever after. Interest rates tightened. The 10-year Government bond yield is now up either 50 basis points or 100 basis points depending on your reference. It is above 8%. The RBI had to announce a special repo window to help debt mutual funds meet redemption demand.



The Business Standard wrote in an editorial that the RBI had thrown the baby with the bathwater. Someone in the know of things (both contemporary and history) exchanged emails on Thursday morning with Yours Truly, called it bloodletting and wondered if the impact of interest rates on exchange rates was as significant as its impact on growth and inflation. What my email partner asked was a rhetorical question on the importance of the exchange rate for India. Rhetorical questions, as opposed to their non-rhetorical counterparts, have their own answers. The implied answer was that the exchange rate effect was not that important to warrant hiking interest rates effectively by 200 basis points in one stroke and choking the economy.

RBI should share its rationale with the public

What we have here is an information gap. Surely, the RBI must have done some work, scenario building to conclude that beyond a certain threshold, the exchange rate mattered for India more than it should or it would, under normal circumstances and that it would be damaging to let the USDINR find its own level. That is the problem or the beauty of economics (depending on the eye of the beholder). Most of what we know is true, within certain limits. Things are linear within normal ranges. Then they are non-linear. I will make myself clearer. For a relatively large economy like India, interest rates should matter more than the exchange rate in influencing economic growth. That is largely true except when it is not.

In fact, many view exchange rate depreciation as loosening of monetary conditions. Again, it is true except when it is not. When the financial market is running amok with greed or loses its head with fear, these statements remain suspended. May be, for a long time too. Exchange rate depreciation is good, if it is happening in an orderly manner and in the context of a normal economy – reasonable growth, inflation and external balances. If not, it could be a harbinger of trouble, a sign of vote of no-confidence on the part of the market. That is what had begun to happen with the Indian rupee. The rupee weakness had acquired a momentum of its own. It was breeding self-fulfilling expectations of further depreciation. It appeared that the floor had been permanently removed from under the Indian rupee or so the RBI must have concluded. That would have quickly turned into a run on India’s foreign exchange reserves given India’s substantial external debt stock and servicing obligations.[2]

On the question of whether the interest rate defence would adversely affect growth even as it has only a limited impact on the exchange rate, the answers are several. Lack of trust in the government has hurt India’s growth and investment more than interest rates. Second, a drastic hike in interest rates is a signal of what the central banks thinks of the fair value of the exchange rate and its determination to defend that. Third, generally, other factors may influence the Indian rupee exchange rate more than the interest rate does but, on occasions, the interest rate defence can be effective. That is a matter of judgement and that is what policymakers are paid for – to exercise that judgement. If interest rates did not matter for the exchange rate of the Indian rupee, the Reserve Bank of India would not have deployed that in the past, especially in 1998. In my view, this is one such time too.

It would help the public understand policymakers better if the latter shared their thought processes or analysis with the former. In other words, RBI needs its own Jon Hilsenrath. More importantly, there must be something to feed the Indian ‘Hilsenrath’. The central bank must sponsor research, conducted by unbiased academics, that illuminates the bank’s actions.

Why did RBI measures taken on 16 January 1998 work?

My email partner on Thursday morning pointed to what the RBI did in 1998. RBI had taken a set of measures on 16 January and another announced another package of measures on 20 August. The measures announced in August were in response to the global emerging market contagion triggered by the Russian default. Measures announced in January were in response to the rupee exchange rate dynamics. From a low of around INR35.7, the US dollar had appreciated to a high of INR40.65 on January 15, 1998. This prompted the RBI to announce a slew of measures on January 16, 1998. It included a hike in the bank rate from 9% to 11%, a hike in the cash reserve ratio from 10.0% to 10.5% and an increase in the fixed repo rate from 7% to 9%. The most interesting of the measures was that the reverse repos facility would be made available to Primary Dealers in Government Securities market at Bank Rate, henceforth on discretionary basis and subject to stipulation of conditions relating to their operations in the call money market.[3] Within a few days, the USDINR exchange rate declined within a few days from 40.65 to 38.60.

The market reaction has not yet been as kind to Dr. Subbarao as it was to Dr. Bimal Jalan then. Well, 1998 was fifteen years ago and that is a long time in the contemporary world. India’s economic fundamentals then in the words of Dr. Bimal Jalan (sometime in June 1998),

Speaking about India’s macro-economic conditions, he said that in the last three years, on an average, India has maintained a GDP growth rate of 6.6 per cent. It had also had an inflation rate of about 5.7 per cent, one of the lowest in the developing world, and a sustainable current account deficit of 1.4 per cent, he said. During this period, external debt to GDP has also been reduced from 32.3 per cent in March 1995 to 23.8 per cent in September 1997. The debt service ratio has also been reduced from 26.2 per cent in 1994-95 to an estimated 18.3 per cent in 1997-98. (Source)

India would wish to have those vital statistics now. Almost all the parameters mentioned above are worse than they were then and some considerably so. Second, the epicentre of the 1998 Asian crisis was not India. This time, India is the problem. That explains the different market reaction to Subbarao. As I write this on Thursday, the US dollar is approaching the 60 rupee level again.

My email partner pointed out that, with the jump in the yield on the Indian government bond, the RBI would be forced to do ‘Open Market Operations’ (OMO). In plain English, the RBI would have to buy government bonds to prevent the yield from moving further higher, negating its own actions taken on 15 July. That is a fair point and quite correctly illustrates the predicament of the RBI. Vindicating my friend was the cancelled Government of India debt auction on 17 July. RBI did not allot any bonds to the bidders since the bidders wanted higher yields than what the RBI was willing to pay. We should note here that RBI is the debt manager for the Government of India, helping the latter to borrow to meet its spending plans.

Here is where one must spare a thought for Dr Subbarao. He has had the singular misfortune of having to serve under a government that has been, arguably, the most incompetent and most venal since independence. His predecessors have not been so unlucky.

Lessons for the RBI (and policymakers in general)

RBI’s lessons in this episode are many. It is appropriate for it to retain a measure of surprise element in its policy pronouncement. I am all for it. However, post-facto, it should put its case for doing so in the public domain. That should be as rigorous as possible. Then, it is important – and this is a lesson for all developing economies and not just for India – not to be overly mindful of monetary policy and economic developments in the US. Admittedly, that is a matter of judgement and, hence, more of an art than science. In 2009-10, as uncertainties loomed large over the fate of Western economies, central banks in emerging economies took the easy way out. They kept their monetary policies too loose too and avoided harsh decisions. Let there be no mistake. Their governments must have heavily leaned on them to do so. However, that is an occupational risk for technocrats in the developed world. Political pressure is a constant. That cannot be an excuse.

Further, they failed to notice that, rather unobtrusively, the dynamics of emerging vs. developed world had begun to change in 2010. It is a fact that financial markets view ultra-loose policy in the developing world and its consequences with different lens than they view developed economies. Financial markets are not apolitical, not neutral and not far sighted. The United States – the Federal Reserve and American financial institutions – and Europe, to a far lesser extent – are the players, the plaintiff, the prosecution, the witnesses, the jury and the judge – on macro policies elsewhere in the world.  It is as much a financial market reality as it is a geo-political reality. That is why it is important for technocrats in the developing world to ignore domestic political pressures in their decision-making. Politicians, especially in India, are neither focused on national interest nor are they capable of factoring in geo-political realities into their calculus.

At the same time, it would be incomplete to conclude this piece before pointing out that the United States or any other nation would not be able to achieve its geo-political goals but for the willing complicity and hubris of policymakers in developing world. One of their strategies is to lull the developing world into a sense of complacency about their achievements and then to pull the rug from under their feet. This would not be possible if policymakers did not have a finely honed sense of their own achievements, failures and structural weaknesses. For all its aversion to the ‘India Shining’ campaign, the UPA-led India fell for the hype about India’s permanently high growth not only due to five years of strong growth starting in 2003 but also due to the so-called quick recovery after the global crisis of 2008. Hubris did India in. India felt that it could get away with loose fiscal and monetary policies because it felt that financial markets were besotted with its high growth rate. In the process, it allowed the economy to overheat and the cookie crumbled. For policymakers in India, scepticism and vigilance would be better policy tools than pride and complacency.

Of course, this is water under the bridge for Dr Subbarao and the RBI. It would be unfortunate if their decision was purely motivated by the fear of going to the IMF for special assistance in an election year. That might yet prove to be unavoidable with the RBI tightening imposing additional costs on the economy. An IMF bailout would have been no bad thing for the Indian economy in the long-run even if it would have meant the death-knell for the UPA government because that is precisely what a good doctor would prescribe for India now.

[1] The weekly column appears on Tuesdays and this is the one that I am referring to (‘what should the RBI do and why?’). The article is behind a subscription firewall.

[2] The elephant in the room is the foreign currency debt obligations of Indian borrowers. The stock of foreign currency denominated debt has grown too rapidly in recent years and so has the cost of servicing it. A recent blog post neatly summarises the burden. A weakening rupee makes both servicing and repayment of foreign currency debt more difficult.

Update: The original piece has been revised to reflect some changes.