RBI should take advantage of the window offered by the Chinese devaluation to cut rates by 0.25% immediately
The dramatic movements last week after China surprised the markets by devaluing the yuan have modified the (already modified) old adage that when the US sneezes, the world gets the flu. Now, additionally, when China sneezes, the world gets a cold—time for all of us to take our vitamins.
And to determine whether we may need stronger medicine, we need to understand, to the extent possible, what’s going on.
There are three broad analyses of the situation. The first is that the Chinese, having discovered that their new model of trying to switch to domestic growth is not working, have decided to revert to the old model—keeping the yuan weak—that worked for so many years. This would suggest continuing yuan weakness.
The second is much more alarming and suggests that the government’s efforts to manage the economy in a more open environment are falling apart; the dramatic fall in Chinese equities a few weeks ago and the government’s ham-handed responses points in this direction. The yuan devaluation, under this analysis, suggests that things are getting more out of control. This would signal a dangerous increase in volatility in global markets.
And then there’s the third analysis, confirmed by the Peoples’ Bank of China itself [by word (?) and deed], which indicates that things are actually going according to plan and that widening the yuan’s daily trading band is simply a step towards making it more market-driven to comply with the IMF’s requirements for inclusion in the SDR. This would indicate that the government remains in control and the devaluation hits two birds with one stone, since a weaker yuan will also help exports in a difficult global environment.
While this is surely the most optimistic scenario, even if true, it doesn’t necessarily mean immediate relief for most economies, particularly those dependent on commodity sales to China and those fearing dumping of excess Chinese goods in a wide array of industries. Further, it is likely that the yuan will continue to remain weak, if not weaken further.
The good news is that global equity markets, at least, appear to have shrugged off the move. The Dow (which is the only equity market that really counts) fell by nearly 250 points the day of the devaluation, its largest decline in about three months; however, it has remained flat over the next two days and, importantly, on Friday, it held its own—and actually rose a little. This indicates that the market doesn’t yet see China’s sneeze as too serious and the focus will shift back to will she or won’t she—raise interest rates in September, that is.
In the meantime, India (like all other countries) needs to develop its response. Simply reaching for a handkerchief to bottle up the cold—in other words, status quo with RBI buying and selling dollars to “control the rupee’s volatility”—would be, to my mind, not just missing an opportunity but possibly dangerous.
India’s exports are showing no signs of life—July makes eight months on the trot of year-on-year declines. Anecdotal evidence abounds of companies having difficulty in increasing sales volumes and Ye Olde FIEO has loudly got into the act. Again, and importantly, the domestic economy remains wobbly—imports are also declining steadily—and key industries like steel (which, amongst others, feeds the NPA trauma at banks) are flat on their back.
RBI Governor Raghuram Rajan, in response to a question at the last monetary policy meeting, said while he acknowledged that a “strong” currency makes exports more difficult, currency is not the only driver of export growth.
True, and, indeed, there has been no real correlation between currency depreciation and export growth over the past couple of years.
Ten out of 20 countries we studied showed falling exports over the past year—this, despite their currencies depreciating on average by 12% since 2014 (neglecting the Russian ruble, which was a wild outlier with an 87% decline). On the flip side, the other ten were able to increase exports by an average of over 5%, ranging from near zero (South Korea and Japan) to over 10% (Mexico, Hungary and Taiwan)—perhaps unsurprisingly, their currencies suffered (enjoyed) an average depreciation of over 20%.
While, as I just mentioned, the correlation is nowhere near definitive, we need to note that the rupee had fallen by just 3% till last week and our exports (again, neglecting Russia) had pride of place at the bottom of the table (of 20).
In my view, RBI should take advantage of the window offered by the Chinese devaluation to cut rates by 0.25% immediately and then by another 0.25% if the Fed doesn’t raise rates at its September meeting. With monetary transmission through the corporate bond market (which, together with CPs, now account for 50% of corporate borrowings) more effective, this should give a reasonable boost to investment. Reforms to the PSU bank system and efforts to improve SME access to finance, while medium term initiatives, would over time dramatically enable this process.
Lower rates should reduce inflows which would assist RBI in gliding the rupee lower, perhaps stabilising it in a range of 64.50 to 66.00 to the dollar, which would represent a 5-6% depreciation from the start of the year. This would give exporters a little more energy and domestic manufacturers some protection from the possibly invigorated Chinese dragon.
Of course, the global drama is just beginning—clearly, there will be higher volatility over the next several months.
The author is CEO, Mecklai Financial