The following is a note written by Yours Truly for a client in the early hours of Friday (July 26):
India’s monetary policy – belated real tightening
On July 15, the Reserve Bank of India (RBI) hiked interest rates effectively by 200 basis points and reduced the amount of liquidity it was making available to banks. However, it was not willing to see market interest rates spike up immediately. Its reluctance to walk its talk showed up in its unwillingness to accept any bids for the one-year T-bill auction last week. Its open market operations (OMO) to sell government bonds and mop up liquidity also saw the RBI sell only a small fraction of the INR120bn it has targeted to sell. This seeming half-halfheartedness drew justifiable criticism. The central bank’s objective of shoring up the rupee was questioned. Some wondered if it was half-hearted. We felt that the RBI had made the right move and we also felt that it was prepared to go all the way to defend its credibility. The only thing we were not sure was whether it meant that the Indian rupee had found a firm floor.
The RBI governor must have thought a lot over the weekend and additional tightening measures were announced on 22 July. The central bank reduced the liquidity made available to banks on a daily basis even further than it did on 15 July. Also, in the 91-day Treasury bill auction, it allowed the yield to spike to 11% from 7.45% in the last auction. The swap curve has moved materially higher compared to one and three months ago. Government of India borrowing costs have gone up across the term structure. This is serious stuff.
Although the RBI hiked the policy rate in 2011 and in 2012, real rates were not climbing since the central bank was playing catch up with inflation and, more importantly, it was forced to undo its tightening efforts by its responsibility as a debt manager to the Government of India. It had to ensure that the government borrowed at as low a rate as possible. That obligation forced RBI to engage in OMOs to buy government debt or to shove government debt on to banks to keep yields down. So, the tightening work was not successful and that largely explains India’s inflation persistence. Now, with inflation having come down, the jump in Indian nominal rates is actually a jump in the real rates of interest. This should support the currency even as it significantly hurts economic activity.
RBI appears determined to see its mission through to its logical conclusion and the mission is to stabilise the rupee. Undoubtedly, the central bank has information on the stress that the weak rupee was causing. Hence its new-found determination. The central bank now cannot turn back half way. That would hurt the Indian rupee much more as it would damage the bank’s credibility rather badly. Therefore, we feel that this move would support the Indian rupee even as it materially reduces India’s aggregate demand and the rate of inflation. It will be a matter of time before the current account deficit begins to come down.
Consensus opinion is beginning to grasp the mission underway. Growth forecasts for 2013-14 and for 2014-15 are being lowered towards the 5% level. That is the upper end of the growth rate range that we have been forecasting for quite some time. The latest moves by RBI create further downside risk to even our growth forecast.
However, with the United States likely to engage in tokenism with its tapering move and with Bernanke having gone out of his way to reassure markets of the likely long duration of policy accommodation and with RBI’s determination, we think that the US dollar has seen its highs against the Indian rupee. The big caveat, though, is that RBI does not blink now.
This follows the weekly column published on Tuesday in MINT.
Niranjan Rajadhyaksha has written a good piece on whether the Indian policy rates are too low. In effect, he defends the recent RBI measures. [Warning: you may face difficulty in accessing the column. I am unable to post the link here due to difficulties in signing into MINT pages. They must do something about it, real fast].
TGS has always held the Business Standard newspaper in high regard. That is why it is particularly hard to record our disappointment at their hyperventilation on the recent RBI tightening. The newspaper has written three edits in the space of less than ten days on the RBI measures. You can read them here, here and here.
One of the first principles of economics is that the effects of economic medicine do not conform to the rules of Twitter and Facebook world. They take time. Hence, it is wrong to write three edits in ten days when the RBI was still unveiling its measures and when a monetary policy statement is due on July 30. Some patience is required.
Second, until recently, most were talking of rates being cut. RBI was obliging, even if grudgingly. Now, for the central bank to turn around and start tightening liquidity while simultaneously causing interest rates to go up effectively by 200 basis points at the short end and, at the long end, by around 100 basis points, there must clearly be some reason. One must give them some credit. After all, it is one of the few institutions in the country with some reputation intact for its competence. Surely, they must have their reasons?
This is what Sajjid Chinoy of JP Morgan wrote, in a research note (24 July 2013):
For starters, it is important to point out that the true tightening has only just taken effect from today, so the results of the current policy need to be judged going forward. Second, whether or not speculation is currently rampant, it is important for the central bank to take these measures to their logical conclusion to preserve credibility. If these moves are seen to fail, the Rupee could come under renewed pressure as markets would conclude that the policy resolve to anchor the currency is missing. For the sake of credibility, therefore, it’s important to stay the course. Finally, if these measures stay beyond a few weeks they will undoubtedly have a collateral impact on growth. But growth would also be adversely impacted if the FX continues to weaken and inflation is pressured further, unhedged corporate balance sheets come under more stress, and the fiscal consolidation becomes more challenging. There are no easy options at the moment. But now that policymakers have picked one, they need to exercise it fully.
Third, not all reasons can be shared with the public on a real-time basis. The central bank must carefully weigh the commitment to transparency against the risk of setting off a panic. There might have been some actual or imminent default on a foreign currency loan. To announce that in public would set off alarm bells and panic reactions which might be harder to control.
Fourth, neither the central bank nor any one said that the latest tightening measures would have no consequences. They are meant to have consequences and that is to slow down aggregate demand and hence economic growth. That is the price to pay for running up a fiscal deficit, a high current account deficit, high rate of inflation and for running a dysfunctional government for almost nine years.
The reason why economic growth has to really fall out of bed is that, even now, neither the government nor the private sector seems to have fully grasped the enormity of the restructuring that needs to be undertaken to get India back on track to some decent economic growth. India is not in the middle of a cyclical slowdown. Far from it. [Arvind Subramanian calls for a variant of an IMF programme in India without bringing the IMF actually into the picture]
Perhaps, a real growth shock is what was needed to get some structural reform (FDI liberalisation is not structural reform) going and to put the implementation of the Food Security Bill in the backburner. Of course, this is my fond hope that the growth impact caused by the recent spike in interest rates would last long enough to raise government’s borrowing cost, to reduce its tax collections and hence to throw a spanner in the spending programmes, necessitating a roll-back of some or all of them, partially or fully.
If that was the unstated intent of the recent RBI measures, then all strength to those who are doing it and to those who have silently acquiesced in it (from the government).
[p.s: For the record, TGS does not agree with the criticism of Arvind Panagariya of the RBI Governor. There are many reasons. They have been adequately covered in various blog posts and columns in the MINT. Just one rebuttal would do: liberalisation of external borrowing is not a RBI decision but that of the Government of India. RBI may be the one to issue the circulars but they are not the ones taking the decision. For starters, just see these three links. Especially, think about the proposal to liberalise ECB norms for low-cost housing!].