- By Ila Patnaik
In recent months, when government officials suggested that the Indian economy was still strong, most of us thought they were trying to talk up the economy. But RBIs moves to tighten liquidity and raise interest rates this week seem to suggest that the government really believes that economy is strong enough to absorb large shocks like the those meted out by the RBI. A careful cost benefit analysis of the actions of the past few days suggests that they may be making a very costly mistake. Sovereign borrowing would further add to this cost.
First, why has the rupee depreciated India has a large current account deficit that needs to be financed by capital inflows. Ben Bernankes statement suggesting that rates in the US may rise over the next few months led capital to fly out of EMs. Currencies that were being held up by capital flows witnessed sudden sharp depreciation. Along with India, other Ems with large CADs such as Brazil, Turkey, Indonesia also witnessed a sharp rise in currency volatility and significant depreciation. Indias falling GDP growth, high inflation, poor investment sentiment and high current account deficit were unhealthy fundamentals to begin with. The US Fed provided the trigger.
Second, is depreciation bad for India at this point It is bad for companies that borrowed overseas tempted by low interest rates. Those who dont have a natural hedge should either not have borrowed, or have hedged their exposure. On inflation, there may be little exchanger at epass- through as the pricing power of companies in a low growth environment is limited. On the other hand, depreciation is good for export competitiveness and import substitution. Depreciation in a slowing economy can provide a demand stimulus to the economy. (Among the first signs already visible are tourists preferring domestic locations to foreign holidays.)
Third, even if depreciation is not good for the economy, can it be prevented For a short while and at a very high cost, yes. Remember the basic principles of the impossible trinity: You cannot have a pegged exchange rate, an open capital account and an independent monetary policy at the same time. So we can give up monetary policy independence to peg the rate. We saw RBI do that with its interest rate defence. It raised rates despite having convinced us that despite the high inflation, the low growth in the economy had led it to lower its inflation forecasts, and the time for easing monetary policy had come.
So, yes, the rupee can be defended and it comes at the cost of raising rates at a time when the economy can least afford it. But with the tightening, the already poor sentiment about the economy, will fall further. RBI has argued that it raised rates not to attract capital inflows, but to kill speculation. So was the rise in interest rates,such as the call money rate going above its corridor to 9%, merely an unwanted and unexpected side effect If so, it speaks volumes about the competence at RBI. And if not, it suggests that RBI is engaging in doublespeak where it is tightening liquidity that leads to higher rates,while suggesting that it is not tightening monetary policy as the repo rate has not been changed.
Fourth, are there any quick-fixes available While the rupee may go up, the fundamental problems of the economy that have lowered productivity growth remain unaddressed. In the long run, if productivity growth in an economy is weak, it should be expected that its currency will depreciate. So, even if RBI is able to prevent further rupee depreciation for a while, unless the government addresses issues of infrastructure, land, labour, access to finance and the innumerable hurdles to investment and productivity growth in the economy, the rupee will continue to weaken in the long run.
RBIs defence of the rupee and the statements of various government officials suggest that the rupee has become too weak, that the fundamentals of the Indian economy are stronger than what the currency market is suggesting and the rupee should in fact be stronger. In other words, they believe that the market is wrong in thinking that there are fundamental weaknesses in the Indian economy. Instead of deluding themselves, policy makers might do better listening to what the rupee is telling them.
(The author is a professor at NIPFP)
Bond issuance will alleviate short-term concerns on the funding of cad and assuage the negative sentiment enveloping the rupee. it may act as a check on govt spending and may ensure commitment to fiscal targets.
- By Shubhada Rao
The new normal of rising yields on US treasuries and concomitant dollar strength has created new dynamics in the global markets. The collateral damage of the changing global dynamics has manifested in dwindling of capital flows to emerging market economies, resulting in weakening of their currencies. The fears of end of easy money have spooked the market sentiment leading to FII outflows from debt and equity markets. Furthermore, the worries have been accentuated due to mounting pressures on the current account gap, exacerbated further by rising oil prices. A combination of these hasled to persistent weakness in the currency, which has depreciated by more than 9% this fiscal year. The gap created by the weakening of FII inflows has prompted a debate around the need to tap the global financial markets to build the foreign exchange reserves kitty.
Essentially, the debate has centred around the timing and the mode of raising fresh capital flows. A build up in foreign exchange reserves is expected to calm the nervous currency markets. Measures undertaken by RBI and Sebi so far, to stem weakness in the rupee, have helped to impart some stability to the currency by curbing speculative transactions in the currency market. The government, on its part too, has been taking measures to restore investor confidence by expediting project clearances and liberalising FDI limits in many sectors. While these steps will yield results overtime, the immediate need is to contain the pressures building on the current account deficit (CAD).
We believe further attempts at containing CAD should be made by taking some bold and harsh measures such as steeper adjustments to fuel prices and restricting gold imports and discouraging other discretionary consumption imports through higher duties. These measures, if implemented, will send a very strong signal about the governments resolve in restoring CAD dynamics on a sustainable path. In reality,these measures may be difficult to implement completely in an election year. Under these circumstances, the options to tap unconventional sources of reserve accretion like sovereign bonds can be explored.
Notwithstanding the fact that funds raised through bonds could mitigate near-term risks and provide some time for the measures undertaken by policymakers to have its effect, the issuance of dollar-denominated bonds involves some risks. Recent international experience in sovereign bond issuance suggests that this route entails high cost on the exchequer. The bond issuance would also increase the duration of Indias debt profile and may lead to further dent in in visibles account through debt servicing costs.
A sudden reversal in global liquidity scenario or change in risk perception of India may trigger investment outflows adding to external sector vulnerability. However, on the positive side,bond issuance would alleviate short-term concerns on the funding of CAD and assuage the negative sentiment enveloping the rupee. Moreover, with subscription to these bonds linked to Indias sovereign rating, it may act as a check on the governments spending and may further ensure commitment to fiscal targets. One way of circumventing the risks of sudden withdrawals owing to change in global risk appetite would be to consider issuing dollar-denominated bonds targeted exclusively at non- resident Indians with an option of redemption only at maturity. In the past, India had successfully raised funds through dollar- denominated NRI bonds in 1991,1998 and 2001.
Episodes of dollar-denominated NRI bond issuance in 1998 and 2001 are likely to have been triggered by worsening of certain external sector parameters such as debt to export earnings and forex cover ratio although the ratio of short-term debt-to-GDP and import cover were comfortable. In FY01, ratio of external debt to export earnings was more than 150% and forex reserves covered only 42% of total debt. It should be noted that recourse to sovereign bonds can act as a short term remedy. In the long run, there can be no substitutes to sound macroeconomic fundamentals.
(The author is Chief Economist, Yes Bank)