Policy conundrum at its best

Written by Indranil Pan | Updated: Sep 19 2013, 07:26am hrs
As we head into the maiden monetary policy statement of RBI Governor Raghuram Rajan on September 20, expectations have started to build on a reversal from the tight liquidity measures instituted onwards from July 15, 2013, whereby the overnight rate was jacked up by a massive 300 bps. The basis of this is that Rajan, when he was the chief economic advisor at the finance ministry, had talked of the interest rate measures being temporary in nature and hence could be looking forward to reversing these at the earliest opportunity. Corporate India also thinks that it was too much of a sledge-hammer that was used by RBI to contain currency instability as it risks a sharp increase in the NPAs of the banking system and has the potential of pushing down growth further than the current levels.

The key question that is on everybodys minds now is whether the interest rate measures that were announced to quench the volatility in USD/INR (dollar-rupee exchange rate) have been successful or not. On July 23, when the second round of measures to tighten liquidity was announced, the USD/INR was at 59.77 and fell to 60.49 on July 30, the day RBI announced its mid-quarter monetary policy review. However, thereafter, there has just been an almost unchecked slide in the USD/INR to an all-time low of 68.85. Some semblance of stability has now come back to the domestic currency markets after the OMCs were allowed a special swap window by RBI to source their dollar requirements and after measures taken by Rajan (FCNR(B) deposits to be swapped at a concessional rate with RBI and banks allowed overseas borrowing up to 100% of Tier 1 capital) on September 4. Thus, it may appear to be a no-brainer to argue that rather than interest rate measures, addressing avenues that boosted dollar reserves and reduce demand for dollars may have had a bigger influential on the dollar-rupee exchange rate. On the basis of this argument, it is logical that the tight interest rate measures need to be reversed immediately.

However, this issue may not be as simple for RBI as it might appear. The issue pertaining to the efficacy of the interest rate measures will always remain debatable as no one would ever know what could have happened to the USD/INR if such measures were not enacted at that particular point in time. Rajan, post RBIs monetary policy on July 30, indicated that RBI policy saw the main immediate macroeconomic task as that of stabilising the rupee, and believes that once the rupee is stabilised, the policy makers will make room for more growth friendly measures.

But, more important is to understand if there were any compulsions for RBI to go the interest rate route. In my opinion, probably yes. Unfortunately, all the FX resources that India lost during the financial crisis of 2008 were never recouped in the following years. On the other hand, the inflows into the economy have just been building up on the debt side as the interest rates in India (and also in the other EM economies) were much higher than the developed markets (DM). More importantly, the central banks in the DM economies had been pumping in liquidity that flowed down to the EM economies in search of more attractive returns. Thus, especially for India we have a scenario where even though FX reserves look to be attractive, the relative usefulness of the FX reserves to contain currency depreciation pressures is limited. This is because the short-term debt for India is high at $172 billion and also a 4-month of import cover as prescribed by the IMF amounts to $80 billion. This leaves almost no FX resources for intervention, and hence the interest rate route.

So, what can be expected from the Governor on September 20 Given the current trends in USD/INR, can we imagine Rajan thinking positively and assuming that the task of stabilising the rupee is over I hardly think this may be the case. And, this is probably the first time I am seeing domestic interest rate policies of RBI getting conditioned by the policies in the rest of the world, now especially the Fed. This is because of a stark reality staring at usthe reality of money being pulled out of India as Fed reduces its QE accommodation. And the very fact that RBI is looking seriously at this uncertainty is evident from the change in the date of the monetary policy in India to cross over and factor in the steps that are taken by the Fed. On the more harsh side, if the Fed starts its QE taper in September, there will be market expectations building up of more taper to come, implying that the uncertainties would continue in the global financial markets and hence it would probably be more difficult for the RBI to withdraw from the MSF measures.

On the domestic macro fundamentals, conditions are not conducive to see an easier monetary policy. Unfortunately, there are too many hopes that are being laid on Rajan and his monetary policy steps to provide a buffer to the falling growth. And, inflation has again started to rise, thereby once again restricting the room for monetary easing. Thus, my first take from the current scenario is that the RBI can do little to perk up growth through an easier monetary condition. The answer to growth lies elsewhere, at the government quarters, where right decisions so as to boost investments need to be made, a hard look at policies that have led to an environment of sustaining high inflation in the economy needs to be taken (such as the consumption boosters in the post-Lehman phase, some of which still exist today) and ultimately a correction in the fiscal space related to lowering wasteful expenses such as subsidies need to be addressed.

This actually brings us to a situation where we can start thinking of RBI starting to tighten monetary policy rather than loosening it. Rajan had clearly indicated that the source of inflation is not crucial, guiding stable expectations of inflation is more important. India would have to compete against most of the other EM economies so far as attracting resources is concerned and others such as Indonesia and Brazil had been raising their benchmark rated recently. Further, the need is also to boost domestic savings by allowing savers positive real rates of returns on their savings, only possible by raising nominal rates as inflation has refused to come off.

Finally, to me, this monetary policy would be more of a watch-and-go policy for the RBI. If the tightening by the Fed is more aggressive than the priced-in amount of $5-10 billion withdrawal a month, then there may be no option for the RBI but to hike the repo rate. Or else, the chosen strategy could be to narrow the interest rate corridor from the current 300 bps to say a 250 bps to start withby reducing the MSF rate by 25 bps and also increasing the repo rate by 25 bps. These are interesting times and I consider it a privilege as a macro-economist to witness such a phase in my career span.

The author is chief economist, Kotak Mahindra Bank Ltd.

Views are personal