The central bank is learning the hard way that inflation targeting is not the panacea it was so sure about
It was only two years back, during September-December 2016, that RBI successfully redeemed the $26 bn FCNR (B) deposits raised in 2013 with barely a tremor in the forex markets. Many were then quick to credit the new inflation-targeting monetary policy regime introduced by former Governor Rajan to tame inflation and preserve “both internal and external value of the rupee”. With domestic inflation stabilising around its 4% target, food inflation nearly dead and forex reserves at $425 bn, most supporters of the new regime hoped the ghost of the “2013 taper-tantrum” wouldn’t ever return or at least not in the immediate future.
Less than two years down the line, however, the rupee has weakened nearly 15% against the USD, the steepest fall amongst its Asian peers, while rising external sector vulnerability is testing the nerves of the new regime. Quite frankly, the regime’s advocates have oversold its success in sustaining macroeconomic stability and investors who accepted this as a ‘structural reform’ are responding with panic selling. Foreign portfolio investors (FPIs) have sold a net $13 bn in 2018 so far. As analysts revise their FY19 current account deficit (CAD) forecasts sharply upward—the IMF’s October 2018 World Economic Outlook estimated the CAD to be -3% of GDP, up from -2.3% in April—and global market conditions tighten, the rupee runs the risk of falling further and faster.
However, the markets weren’t prepared for it. They expected RBI to raise interest rates to defend the currency’s free fall, a conventional policy response. Little surprise then at their adverse reaction when RBI kept the policy rate unchanged at its October 5 monetary review. This has brought to the fore several misgivings regarding the scope and tools of India’s flexible inflation targeting (FIT) regime. While the central bank took a conservative view that the interest rate tool would only respond to exchange rate pass-through captured in domestic inflation, markets insisted it could very well accommodate the dual objective of exchange rate stabilisation. Only time will tell if RBI is able to stick to its present stance and if the rupee’s declines were to accelerate. But the strong-pitched arguments on both sides were disconcerting as the regime’s fault lines stood exposed.
What rattled markets even more were the forthright post-policy comments of the Governor and Deputy Governor that RBI would let exchange rate adjustment help reorient the current account balance given reversed terms-of-trade. For rarely, if ever, has the central bank been so candid about the exchange rate direction at turning points. In this, the central bank can be interpreted as communicating that the rupee’s current and future path is guided by fundamentals or the current account. Accordingly, it hopes a weaker rupee should stimulate exports, slow down imports and bring the current account deficit within the comfort zone of -2.5% of GDP. Yet, there isn’t indication if a weakened rupee has been able to provide the necessary thrust for accelerating export growth that turned negative in September 2018. RBI must be wondering how much more the rupee should depreciate to find its fair value. HSBC analysts speculate the rupee could drift down to `79 per dollar in FY20. Such assessments should worry RBI. Having communicated its intent to the market in no uncertain terms, the central bank risks the weakening of the rupee at a faster pace as market expectations get aligned in that direction. That RBI sold $5 bn of forex reserves in the week following the announcement is certainly unnerving!
Should RBI look at the REER to guide the future course of the rupee? Unfortunately, there is some difference in the views on what is the best estimate. The Bank for International Settlements’ (BIS) internationally comparable cross-country REERs suggest the rupee was closer to fair value in September 2018 at 100.2 (2010=100). This intuitively appears less appealing considering exports lost momentum even as global growth remained robust. In contrast, RBI’s own REER estimates suggest substantial overvaluation with the 36-currency (2004-05=100) trade and export weighted REERs of 111.4 and 113.35, respectively, the same month.
But REER estimates are not so useful a guide to measuring misalignment—historical research finds these fluctuate around the economy’s equilibrium REER. Thus, a sense of how fundamentals have moved over the period is essential, especially to judge if the economy has been losing competitiveness. Apart from the turn in terms-of-trade, compelling domestic factors could also have adversely impacted productivity, such as the prolonged and ongoing crisis in the banking system and erosion of productive assets, stalled infrastructure projects and related cost escalations, raised cost of capital following changes in the monetary policy framework, and higher protectionism from the raising of customs tariffs across product lines. Temporary supply chain dislocations from the sudden shock of demonetisation and disruptions from a faulty GST design and implementation could only have accentuated the problem. If indeed so, the estimated REERs might have been significantly misaligned relative to the equilibrium value, an indication of a highly overvalued rupee!
In that case, the rupee would have a fair bit of ground to cover and the time horizon for such a correction would be critical for RBI to manage an orderly depreciation. The proxy, however, would continue to be the evolving trend in the current account deficit (CAD) as the best guide. The current account has structural weaknesses and would need time to correct. Unlike 2013, when the government applied the brakes on gold imports to achieve a sharp CAD correction in a quarter, there isn’t such a lever this time round. Markets are least convinced if levying tariffs on some items will have any meaningful impact. If the interest rate tool is off the table for stabilising the rupee and the government is unwilling for tighter fiscal consolidation to cool domestic demand, then imports can, at best, moderate more slowly to the rupee weakening. Similarly, exports have exhibited lower price elasticity but relatively stronger income elasticity in the past; a projected slowdown in global growth and trade suggests exports, too, may recover gradually. And so, prospects for any sharp CAD correction in FY20 would hinge essentially upon stabilisation of international oil prices. Needless to add that, given tightening financial conditions abroad and trade-related uncertainties, the rupee would continue to see volatility with a downward drift and would be dependent upon the dynamic interplay of evolving current and capital account flows.
The central bank is learning the hard way that inflation targeting is not the panacea it was so sure about—lower domestic inflation that enormously benefitted from favourable terms of trade could give way, in equal measure, when the tide turns the other way! With forex reserves fast depleting, there may be temptation to mobilise external financing from international markets or non-resident Indians. But RBI must carefully evaluate if that would be prudent. Replenishing dollar reserves would certainly stabilise the currency in the short-run and buy some time. But if the government fails to commit itself to sharper fiscal correction and pushing key export-supporting structural reforms, the pain could stretch longer, i.e., increasing uncertainty in anticipation of future volatility until the CAD exhibits fundamental corrections.
The writer is a New Delhi-based macroeconomist