Jahangir Aziz, chief economist at JP Morgan, believes that the huge depreciation of the rupee has resulted in a significant loosening of monetary conditions equivalent to perhaps a 200-300 basis points rate cut. The bigger worry though, Aziz tells Shobhana Subramanian, is that inflation may not come off to the expected 7.5% by March 2012, after which there will be no base effect either.
What is the correct value of the rupee?
It depends on how you look at it. Based on the inflation differential between India and the world, the rupee needed to depreciate. If you look at it from the point of view of the higher growth in India?India was growing at 8% while its trading partners were growing at 2%?then the rupee needed to appreciate. There was some overvaluation even at July levels, but it wasn?t that large. Since then, the 15% depreciation has brought down the real effective exchange rate back to its pre-crisis levels and even lower, though the monthly RBI data, which is lagged, may not show it.
The weaker rupee has undone much of RBI?s efforts to tighten money…
Because of the nominal depreciation that?s taken place, monetary conditions in India have been loosened massively. So, those who are clamouring that monetary conditions are tight need to look at the relative weight of the exchange rate in the monetary conditions index, because it is pretty high. And the fact that the rupee has now depreciated continuously since August suggests that a significant loosening of monetary conditions has taken place, which is probably equivalent to a 200-300 basis points cut in interest rates.
So, RBI doesn?t need to cut interest rates for at least six months?
Unless the exchange rate again appreciates, in which case one needs to take stock of the situation. But the entire policy of keeping money tight so that inflation comes down has been completely undone. What?s worse is the impact it has had on the fiscal deficit. Our estimate is that it has added R40,000 crore to the oil subsidies and fertilisers. Far more scary is the fact that the strong base effect for inflation, which would have come into play after December and till March next year, was there when the rupee was at 45. At 52, that base effect has been eroded so much that it isn?t clear now whether we will get to the 7.5% inflation mark by March.
Exporters are increasingly holding back because they expect a further depreciation and that?s becoming a self-fulfilling prophecy. And, in the absence of a sovereign being present there and providing a floor, there is no consensus on where the rupee can go.
RBI believes it?s unwise to defend the currency with reserves…
RBI?s logic is that in current account deficit countries like India, reserves are increased because of capital inflows and, therefore, when these reserves have a counterpart, foreigners are holding assets in that. So, when they move money out, that?s the time for intervention. So, in October-November 2009, when there were outflows, RBI did intervene to the tune of roughly $10-12 billion, because they wanted to stem the outflows. The depreciation started in early August post the US downgrade; the argument was that if you are a current account deficit country then the currency must depreciate, and in a world in which global risk has gone up, there?s no reason why capital flows should come in. Asian currencies, even though they depreciated, recovered because they?re all current account surplus nations. But, despite that, Korea reportedly intervened with close to $22-23 billion and Indonesia put in $8-10 billion, while RBI is reported to have intervened to the extent of $5 billion.
Was that the right thing for RBI to have done?
The trigger for the fall of the rupee was the US downgrade, but the drop from 47-48 to 52 was entirely the result of speculation by exporters. RBI did not do the math; if one takes the exports from April to October and adds to that seven months of services exports, the market should have seen around $120 billion worth of dollars being sold. But no one seems to believe that this amount has been sold. Some of the money may be in the EEFC accounts with banks but it still doesn?t add up. So where is the money? If we believe the non-customs data, unless there have been some large defence imports, people are keeping money out. We get the impression that exporters haven?t sold as much as they should have.
So, do you think RBI should have defended the currency?
I think RBI should have defended the rupee and they needed to figure out the right drivers of the depreciation rather than wait so long like they did with inflation. If you believe there is excess demand, you need to manage that even if unfortunately there is massive collateral damage in terms of lower investment. My point is that the same problem that characterised the hesitant approach to inflation is being seen again; there too, they were not sure of the drivers of depreciation. It took them almost three months before they believed that all of this was being driven by a self-fulfilling prophecy. But the intervention again is being done in baby steps. The same problem that allowed inflation to slip through their hands and forced them to take stronger measures?more rate hikes?is getting repeated. The Swiss central bank is a good example of how to intervene. You really didn?t need the intervention to be such as to push the rupee back to 45; the market will do it for you, provided you signal that you will make their short positions painful.
So, if inflation isn?t coming off, what would RBI?s stance be?
RBI will not cut rates and neither will it cut reserve requirements because the monetary conditions have reversed. We won?t get to 7.5% inflation by March. If we?re lucky, in the sense that if from now until March we do get some intervention or if exporters sell, we may get just above 8%. But the base effect almost disappears after March, and from May onwards it?s back. RBI knows this and therefore won?t cut the CRR. If it wants to inject liquidity, it can do so through OMOs and my sense is that RBI will at least do a couple of more OMOs, perhaps R50,000 crore, to help the government.
So, how far has the turning of the capex cycle been postponed?
We believe it has been postponed to the second half of 2012, at least unless the government regains control over the macroeconomy. What is disconcerting is that the 15% depreciation has added significantly to the costs of projects and moreover, no one?s looking at growth beyond 6.5-7%; and inflation has raised costs across the board. That?s one reason why we are seeing sluggish investment, because the viability is being hurt on the demand side; there?s not enough demand. That?s weighing more on the minds of promoters than the costs.
What?s a sustainable growth solution for India in the next few years?
Right now, there is a binary solution to the eurozone, which is either that the ECB steps in directly or indirectly through the IMF. We believe that the ECB will step in perhaps through the IMF, but there is nonetheless a risk, and that has pushed up funding costs and so there will be some pressure on the funding market in India. India?s growth rate depends on how quickly the government navigates the political opposition and gets Parliament going; it can put together a reasonably good set of reforms and policies and generate confidence. If they do that, we can go back to 7.5% or even 8%. If they don?t, we can get stuck in the 5-6% handle. Mining is going to remain negative because the allocations were done too late and the power sector, too, has problems.
I?m far more worried about inflation hitting consumption demand rather than interest rates. I think the government will take some ad hoc, not well thought-out, measures in the next budget, even without the populist moves. And they will be under pressure to do something, so we will have a situation where the fiscal deficit runs the economy, provides a little spurt of growth but kills private investment. That?s a big worry, that the government will not be able to come out with a well thought-out package. Perhaps there will be a Food Security Bill taking the food subsidies to around R85,000 crore depending on the parameters, though the major impact will happen this year. The deficit could go up to 5.5% this year.
Could the Indian stock markets see a de-rating?
At some point, serious questions will be asked on the top line and if top line has to be delivered, our corporates cannot be sitting on cash. Corporates can explain that cash by saying there is uncertainty abroad and at home. But that cannot be forever.