At the turn of the last century, US President Teddy Roosevelt famously said that foreign policy should be conducted by ?speaking softly and carrying a big stick.? But the analogy obviously doesn?t extend to modern-day central banking. Markets interpreted RBI?s communication on Tuesday as soft-speak and the rupee has tumbled since then. This despite the ?big stick? that the central bank has brought to bear in previous weeks. Financial markets therefore appear confused. Three weeks ago they were shocked that the central bank had resorted to monetary tightening to defend their currency. When the expected liquidity squeeze did not materialise, markets got complacent. Then RBI reiterated its resolve by squeezing more. And just when markets were learning to live with this new reality, they interpreted (over interpreted in my view) RBI?s comments on Tuesday.
Markets are currently grappling with three fundamental questions. Will the liquidity squeeze stay on for long? Will the resultant monetary tightening have a salutary impact on the rupee? And what about the collateral damage to growth?
To answer these questions one needs to understand the underlying motivation of the recent moves. It is undoubtedly the case that the genesis of the rupee?s recent problems is external, that the rupee is not the only currency to have come under pressure, and that there is a more fundamental BoP hole that needs to be plugged. Even after the clampdown in gold imports and the expected clamp-down on non-essential imports, the current account deficit is expected to be in the $75-80 billion range for the year. India?s more stable sources of financing (FDI, NRI deposits, ECBs, trade credits) typically account for $55-60 billion. In addition, the economy annually relies on $18-20 billion in volatile portfolio flows?which have completely dried up this year as the Fed begins to taper.
This gap needs to be bridged and none of the recent RBI actions are meant to solve this more fundamental problem. And they should not. Ultimately, the currency must reflect the BoP and macro fundamentals. But sometimes currency weakness begets more weakness. Old flows leave and new flows stay out precisely because they believe the currency is in a nose-dive. That by itself further weakens the currency and self-validates the initial belief. Expectations get unhinged, the currency goes into a self-fulfilling spiral, and conditions are ripe for speculation. Speculation is not just naked shorting of a currency. It is exporters delaying receipts and importers front-loading payments in anticipation of more currency weakness. In the short run, fair-values often take a back-seat and financial markets can deviate sharply from underlying fundamentals.
This is when central banks need to step in and play a stabilising role. And in a world where foreign currency reserves are finite, the defence typically happens in money markets. Take the case of Turkey. It spent 3% of its reserves to defend the lira on July 10. But markets knew this was not sustainable and the lira kept weakening! This forced the central bank to hike the interest rate corridor and the currency has finally stabilised.
The idea is straightforward?to push up the opportunity cost of not holding the local currency. Furthermore, to the extent that central banks are able to push up the forward premium, they often succeed in altering the inter-temporal decisions of exporters and imports. None of this is witchcraft. Instead, a very conventional defence of the currency.
The key, however, is credibility. Because the idea is to change the behaviour of market participants, they have to be convinced that the central bank means business. Therefore, it was always unrealistic to expect RBI to lay out an explicit timeline for exit. If everyone knows exactly when RBI will withdraw the measures, they will simply wait it out. For the measures to work, there has to be an element of constructive ambiguity about their duration. Furthermore, employing the bazooka approach?tightening liquidity, selling dollars in the spot market, pushing up forward premium simultaneously?can often be just as effective in changing mindsets.
So have RBI?s measures succeeded in stabilising the rupee? With the rupee currently at record-lows this may appear to be an absurd question. But consider this. The tightening measures only really kicked in on July 23. That?s when RBI announced the second round of measures, the inter-bank rate spiked, and the market knew RBI was serious. Guess what? In the one week that the measures were in effect before Tuesday?s policy review, the rupee was the best performing currency among emerging markets with a current account deficit! (See figure.) Also, since the measures were announced FII equity outflows have nearly ground to a halt ($7 million a day) versus a sharp outflow ($90 million a day) when the currency was falling like a stone in the previous 6 weeks. The tightening was working!
But things have changed from policy day. Market participants construed RBI?s tone to be dovish (unjustifiably so, in my view), have questioned its resolve, and the rupee has been the worst performing currency since July 30.
The lesson should be clear. It?s only when markets are convinced that the authorities mean business will the behaviour change. It?s, therefore, even more crucial now that RBI shows unmistakable resolve and takes the measures to their logical conclusion. If these moves are seen to fail, the speculative pressure could be immense, as expectations of an ever-weakening rupee take hold. The rupee has dropped 2% in the last 48 hours on questions of resolve. Imagine the reaction if the measures were prematurely rolled back?
But what about the collateral damage to growth? Undoubtedly, the longer the measures stay, the more the collateral damage to growth. For a beleaguered corporate sector, a spike in funding costs is the last thing that?s needed. Bank asset quality, too, is expected to suffer. The angst is understandable.
But there are no good options. Not doing anything and letting the rupee weaken further has its own damaging growth consequences. It will also stress corporate balance sheets?and therefore bank asset quality?on account of unhedged external commercial borrowings. Plus, it is likely to put meaningful pressure on inflation and further squeeze purchasing power. And with every percent the rupee depreciates, the fiscal consolidation gets more challenging. That cannot be good for investor sentiment and our ratings prospects.
More generally, there?s more at stake than two quarters of growth. If the rupee continues to weaken inexorably because policy is deemed to have lost control, the country could witness a sharp capital outflow. And the risks of severe BoP stress will rise exponentially. Policymakers need to stay the course. And markets need to realise what?s truly at stake.
The author is India economist, JP Morgan