Confusion reigns

It is unclear as to which objective of RBI has been achieved with its recent announcements.

The title of this article is not just about RBI’s bizarre announcement three days ago (Tuesday, August 20) that it had largely achieved the goals it set out for itself in mid-July when it raised interest rates by 200 basis points. Yours truly applauded the move. I wanted RBI to stand firm. It diluted its stance a little when, in the monetary policy communication of July 30, it said that the rate move of mid-July was temporary. That was a confusing signal and second, it reduced the effectiveness of the rate move as it alters expectations and hence, behaviour. Then, this week, it said that it would add liquidity by buying long-dated bonds. The rupee had not stabilised and more broadly, financial market conditions in India had not stabilised. So, it is unclear as to which objective of RBI had been achieved? The announcement of August 20 was baffling, to say the least.


It gives one the impression that there is really no one in charge now or that multiple people are in charge of the RBI at the same time.

Even now, we find careless arguments being advanced about how the rupee should be allowed to find its level. In normal circumstances, yes. If the country fundamentals are right, let asset prices find their own level. If fundamentals are bad, governments have two tasks. One is that asset prices should be stabilised lest they worsen the fundamentals beyond repair (the reverse feedback effect from asset prices to economy will happen) and the government should get to work fast and focused on fundamentals. India is in this situation now.

Arguments as to why the rupee should be stabilised were made by yours truly on several occasions in the last one month. You can find the most recent one here. Also, read this excellent primer by Sajjid Chinoy in Business Standard few days ago.

First, it is careless to argue that a falling rupee would boost exports. ‘Other things being equal’, it might. Other things are not equal. Global demand is weak:

  1. US recovery is shallow and superficial. Just check out the Chicago Fed National Activity Index and the weekly percentage change in new mortgage applications.
  2. Europe is just trying to get its head above water. How long can it stay above water is any one’s guess.
  3. Japan’s Fukushima reactor radioactive water leak – it appears to be a huge problem – is yet to sink into people’s consciousness. It could seriously erode the government’s authority and the PM’s credibility.
  4. HSBC’s Purchasing Manager Index for China prints an inexplicably strong headline number when its the components are weak. Go figure.
  5. Most other key emerging economies are in a crisis mode.

Lastly, Indian costs have gone up so much in recent years and productivity so low that we do not know the extent of rupee depreciation that is needed to make Indian exports competitive again on a sustainable basis.

So, a weak rupee is likely useless when demand elsewhere is anaemic. Second, a weak rupee raises domestic costs. A weak rupee has made crude oil costlier. The 50-paise per month hike in diesel price has been nullified by the weak rupe and firm trend in the global crude oil price. The under-recovery in the price of diesel is INR10.22 per litre as of August 16. Check out the website of the Indian Oil Corporation where it is updated regularly. The under-recovery is the same as what it was when the diesel price ‘normalisation’ started. We are back to square one. If rupee remains weak, the under-recovery would worsen further. Domestic price of diesel has to be raised one shot and freed. Fat chance it would happen.

Third, this point has been made ad infinitum: Indian corporations have borrowed 50 billion dollars in the last four years. The twice-a-year Financial Stability Report of the Reserve Bank of India gives all the information one needs on this. These loans are now anywhere between 10% and 50% costlier to repay because of rupee depreciation. If the rupee were to weaken further, it would make many Indian corporations default on their foreign loans. That would shut India off from foreign debt markets for a long time. It has both reputational and real consequences – serious ones.

So, the rupee had to be stabilised and measures include funding and reducing the current account (CA) deficit. What is the reality?

(1) The Reserve Bank of India has not done enough to stabilise the rupee beyond its rate hike in mid-July. Since then, it has diluted the measure. It has not allowed sufficient time for the rate hike to play out. RBI is being pulled in different directions.

(2) CA deficit must be funded. But, funding it now should not be at the expense of making too many concessions to foreign investors and lenders that would be long-term costly.

(3) Reducing current account deficit means reducing imports. We have seen how export revival is a harder task now. One way to reduce import growth is to slow the economy, near-term. That is what RBI’s rate hike of mid-July would have achieved.

But, that measure is being diluted since the government does not seem to be willing to sacrifice growth further for several reasons – economic (tax revenues), political, etc.

(4) Another way to reduce the current account deficit is to reduce the fiscal deficit drastically – yes, not only the Food Security Bill but many ad-hoc tax concessions made to corporations can and should also be withdrawn now.

(5) Raising import duty on flat screen television set and reducing Indians’ foreign exchange outflows are a bean-counter’s response to the problem.

In sum, the rupee is not being stabilised with full commitment. Hence, financial conditions too would remain instable. The current account deficit is not being tackled the right way because the government is unwilling to pay the ‘growth’ bill for doing so.

What is the way out? It is possible that all the confusion has further undermined India’s business sentiment and confidence and that economic growth would be lower on its own. That would lower imports in any case. Hence, the government’s confusion, prevarication and vacillation appear to be working, in reducing economic growth! That is some strategy!

Investors’ misplaced faith in the economic recovery in the US and obsession with the Fed reducing asset purchases might ease, reducing pressure on emerging market currencies, including on the Indian rupee.

There can always be strokes of luck although the dice has not rolled in India’s favour since 2004.

Photo: Luciano Belviso