RBI credibility coming into question will ensure that the decline will be sharper than in previous episodes
In an excellent article (goo.gl/k4ae2p), R Jagannathan says, “The Narendra Modi government’s decision to demonetise high-value currency notes is nothing if not political.” His articulation is clear and worth reading.
Taking this as a given, and over and above the widely expressed concerns about near-term growth, another—and from a macro perspective, perhaps larger—concern is the shadow all this casts on RBI’s independence.
Demonetisation, while notified by the government, has to be triggered by RBI. Section 26 of the RBI Act states that “On recommendation of the Central Board [of the RBI], the Central Government may, by notification” declare that any series of notes shall cease to be legal tender. Members of the Central Board are, understandably, unwilling to comment, but, given the fact that the government has said that preparations for this move have been on for six months, it could well be that former Governor Raghuram Rajan’s surprise decision in July to leave RBI was triggered by his discomfort with this plan and the government’s insistence on going ahead.
This would also suggest that the current Governor—then deputy governor—was in on it and the apparent process of searching for a successor to Rajan was just eyewash.
If this is true, markets will begin to see RBI more as the government’s lap-dog than an institution that will do what it objectively believes is the right thing for the economy. Global investors would, to my mind, certainly be more circumspect before investing in India; domestic investment, too, would become more skittish than it already is.
Rajan had often said, quite sensibly, that the only thing India (or any country, for that matter) could do to insulate itself from global storms that break out with considerable regularity in the inter-connected world, is to keep strengthening its financial infrastructure. His entire tenure was marked by steady steps to keep building up India’s macro framework—and, to give credit where it is due, the government did play a key role in this. However, this sudden unravelling of the reputation of what was perceived as one of India’s soundest institutions is a reminder, rather like the Tata brouhaha, that hard-won credibility can be lost in one mad moment.
It is never a good time to lose credibility, but, with global markets turning more risk-averse as investors focus on the US economy and the dollar, the timing couldn’t be worse. And, with Trump taking charge in the US, there could be any number of reasons why volatility could spike. Markets have been relatively quiet with no crisis-driven spike in volatility for more than 3 years (as compared to a blow-out every 2.5 years on average over the preceding 20 years). Another global storm seems imminent.
The rupee, of course, is on tenterhooks. It sank like a stone after the one-two bashing of demonetisation and Trump’s surprise victory, losing nearly 4% in a couple of weeks and actually hitting its all-time low of 68.85, before recovering edgily under RBI’s ministrations.
The forward premiums, in a new twist to the tale, fell even faster, as the certainty of a Fed rate hike in December added to the sharp decline in domestic interest rates as a result of the huge inflow of funds into the banking sector. From an already low 5.5%, the 6-month premium fell steadily over the past two weeks to where it is below 4% today. Significantly, the forward curve, which has been downward sloping for years—i.e., the longer forwards are lower than the shorter ones—flipped over, with short-term premiums losing the most ground, confirming that the decline is more because of the excess liquidity with banks (rather than the expected US rate hike, which had, in any case, already been factored in). This suggests that as RBI draws funds out from the banks with the penal CRR (till such time as they have more bonds to sell) and, in any case, once some part of the “impounded” liquidity finds its way back to the market, the premiums are likely to tick up by at least 50 basis points again.
Unfortunately, this is cold comfort to importers, given the sharply lower rupee, and much depends on how the currency moves going forward. Given the likelihood of global—not to mention domestic—fireworks, a lower rupee is certainly on the cards. The credibility issues I have highlighted will ensure that the decline, when it comes, will be sharper and recovery slower than in previous episodes of rupee volatility.
But, on balance, it may end up all to the good—despite the rupee’s fall, the Chinese yuan has fallen some 4% faster since the start of year, which means our companies need that much more support from the currency to compete in still difficult world markets.
The author is CEO, Mecklai Financial