Does India need sovereign bonds?

Financial Express, 24th July 2013

RBI's defence of the rupee and statements of govt officials suggest the rupee has become too weak. instead of deluding themselves, policymakers might do better listening to what the rupee is telling them

In recent months, when government officials suggested that the Indian economy was still strong, most of us thought they were trying to talk up the economy. But RBI's moves to tighten liquidity and raise interest rates this week seem to suggest that the government really believes that economy is strong enough to absorb large shocks like the those meted out by the RBI. A careful cost benefit analysis of the actions of the past few days suggests that they may be making a very costly mistake. Sovereign borrowing would further add to this cost.

First, why has the rupee depreciated? India has a large current account deficit that needs to be financed by capital inflows. Ben Bernanke's statement suggesting that rates in the US may rise over the next few months led capital to fly out of EMs. Currencies that were being held up by capital flows witnessed sudden sharp depreciation. Along with India, other Ems with large CADs such as Brazil, Turkey, Indonesia also witnessed a sharp rise in currency volatility and significant depreciation. India's falling GDP growth, high inflation, poor investment sentiment and high current account deficit were unhealthy fundamentals to begin with. The US Fed provided the trigger.

Second, is depreciation bad for India at this point? It is bad for companies that borrowed overseas tempted by low interest rates. Those who don't have a natural hedge should either not have borrowed, or have hedged their exposure. On inflation, there may be little exchange rate pass through as the pricing power of companies in a low growth environment is limited. On the other hand, depreciation is good for export competitiveness and import substitution. Depreciation in a slowing economy can provide a demand stimulus to the economy. (Among the first signs already visible are tourists preferring domestic locations to foreign holidays.)

Third, even if depreciation is not good for the economy, can it be prevented? For a short while and at a very high cost, yes. Remember the basic principles of the impossible trinity: You cannot have a pegged exchange rate, an open capital account and an independent monetary policy at the same time. So we can give up monetary policy independence to peg the rate. We saw RBI do that with its interest rate defence. It raised rates despite having convinced us that despite the high inflation, the low growth in the economy had led it to lower its inflation forecasts, and the time for easing monetary policy had come.

So, yes, the rupee can be defended and it comes at the cost of raising rates at a time when the economy can least afford it. But with the tightening, the already poor sentiment about the economy, will fall further. RBI has argued that it raised rates not to attract capital inflows, but to kill speculation. So was the rise in interest rates,such as the call money rate going above its corridor to 9%, merely an unwanted and unexpected side effect? If so, it speaks volumes about the competence at RBI. And if not, it suggests that RBI is engaging in doublespeak where it is tightening liquidity that leads to higher rates,while suggesting that it is not tightening monetary policy as the repo rate has not been changed.

Fourth, are there any quick-fixes available? While the rupee may go up, the fundamental problems of the economy that have lowered productivity growth remain unaddressed. In the long run, if productivity growth in an economy is weak, it should be expected that its currency will depreciate. So, even if RBI is able to prevent further rupee depreciation for a while, unless the government addresses issues of infrastructure, land, labour, access to finance and the innumerable hurdles to investment and productivity growth in the economy, the rupee will continue to weaken in the long run.

RBI's defence of the rupee and the statements of various government officials suggest that the rupee has become too weak, that the fundamentals of the Indian economy are stronger than what the currency market is suggesting and the rupee should in fact be stronger. In other words, they believe that the market is wrong in thinking that there are fundamental weaknesses in the Indian economy. Instead of deluding themselves, policy makers might do better listening to what the rupee is telling them.

The taming of the rupee...

Financial Express, 12th July 2013

On July 8, 2013, the Reserve Bank of India (RBI) stopped all banks from carrying out any proprietary trades on currency derivatives exchanges. This means that all rupee transactions will have to be done only when a client approaches for selling or buying foreign exchange.

On the same day, Sebi doubled the margin requirements for forex trading, reduced client limits from the "higher" of 6% (of open interest) or $10 million to the lower of the two, reduced trading member limits from the higher of 15% or $50 million to the lower of the two.

While the RBI notification states "risk management" as the subject of the regulation, the Sebi circular mentions no reason for carrying out the measures.

Apart from these formal notifications, there have been some other eclectic interventions in the markets by RBI. State-run oil companies have been asked to meet their dollar requirements from a single bank (July 9). It seems banks were asked not to make predictions about the rupee in their forecasts to the public.

The harsh reality is that these actions will not help stem the fall of the rupee; in all probability, they make things worse. These arbitrary moves to curtail economic freedom will only worsen the panic and irrational sentiment in the country. As an example, the only country where economic policymakers interfere with freedom of speech is Argentina. It is not good for India to be one of those who curtain freedom of speech on economic issues.

The rupee has become a big global market that is beyond the control of RBI and Sebi. Since 2007, the trade in non-deliverable forwards (NDFs) in the rupee has soared (see figure 1). These contracts are traded in London, Dubai and Singapore and many other locations. Since the rupee is a controlled currency, the settlement happens in foreign exchange. Indian policymakers have succeeded in crippling the growth of rupee trading in India, but they have no say in interfering with the global trading of the rupee. The overseas market has increasingly come to dominate the rupee (see figure 2).

What the RBI and Sebi moves have achieved is to reduce liquidity in the market. This will allow RBI's intervention to have an impact. But this impact is only in the short run. In the long run, trying to create walls between domestic and offshore derivatives markets for the rupee, or in squeezing the size of the market will have little impact on improving India's competitiveness. The lack of growth in productivity and high inflation will weaken the currency and will come back to haunt the economy.

These moves will, however, make the economy less resilient. RBI and Sebi are successful in reducing access to risk management for small companies in India. For any reasonable-sized organisation, the highway is open to take money out of the country and participate in the overseas market.

In the 1970s, Indira Gandhi's government used to think that food price inflation was caused by hoarding of food. Stringent actions were taken against speculators and hoarders. These made no difference to the supply and demand for food. We now recognise that such authoritarian actions are useless in obtaining cheaper food; the path to cheaper food lies in deeper initiatives that increase productivity in agriculture.

In a similar fashion, the government's assault on the rupee market is inspired by the idea of attacking market participants when the market price is considered undesirable. This will fail again. The price of the rupee is ultimately about supply and demand, and about India's prospects. It is convenient and fashionable for policymakers to blame market participants, but the deeper cause of the rupee's decline lies in the macroeconomic mismanagement including high inflation and large deficits. Until those fundamentals are addressed, the rupee will not improve.

The vast global market for the rupee will gladly lap up all the participants that are driven away from the market within India. RBI and Sebi can drive rupee trading out of the country; they cannot prevent it. Indian policymakers will ineffectually preside over an empty and irrelevant corner of the global market for the rupee. It is ironic that recent moves by RBI and Sebi will accentuate their irrelevance.

India has rapidly integrated with global markets. The rupee and the Nifty are signs of the performance of the economy. When economic policy goes astray-as it has in recent years-this will generate instant feedback with a drop in the rupee and Nifty. This is a healthy feedback loop. It immediately brings pressure upon the political authorities.

Emerging markets have understood these lessons. The economic policy apparatus of mature emerging markets knows that it is judged by domestic and global financial markets every day. This pressure has resulted in attempts at improving institutional structures. When bad things happen, the currency and equities are punished. The job of the government should be to try improving the policy frameworks. We, in India, have yet to come to the point where policymakers read these signals as weaknesses in the economy that they need to address.

Losing currency

Indian Express, 10th July 2013

To shore up rupee, policy must boost domestic productivity, assure foreign investors

The sharp decline in the value of the rupee in recent days has led to a clamour for the government to do something. But there are few easy options available. RBI intervention is likely to have limited impact in the face of the huge pressure on the rupee caused by global capital movements. Domestic interest rates cannot be raised to attract foreign inflows because of the decline in growth and investment in the country. Reducing imports though imposing restrictions on gold has had limited effect. The falling rupee is a consequence of global developments as well as a sign of longer-term features of the Indian economy. Addressing the symptoms, that is, the rupee fall, could give us short-term relief, but soon the same problems will surface again.

First, let us place the rupee decline in perspective. When we compare the slide of the rupee to the behaviour of other currencies in June, when the rupee depreciated sharply, it appears as if other emerging economy currencies depreciated less, while the rupee fell sharply. However, when we compare the rupee-dollar rate to other large emerging market (EM) economy currencies, like those of Brazil, South Africa, Korea or Turkey over a longer period, starting in January 2013, we find that most of those currencies had depreciated earlier, particularly between mid-February and mid-March, while the rupee had held up. The US dollar trade weighted index shows similar trends. As a consequence, what appears to be a very sharp depreciation compared to other large EM currencies is not such a sharp depreciation. Indeed, if the rupee had not depreciated, it would have lost competitiveness against other currencies. With high inflation continuing to plague the Indian economy, the recent depreciation has prevented the real exchange rate of the rupee from becoming overvalued. As long as inflation in India is higher, in the long run we are likely to get a nominal depreciation that would prevent real exchange rate appreciation. So if our cost of production is growing at 10 per cent while, say, for the sake of argument, the others are at zero, then after five years, do not expect that the rupee will remain at 60. It should be expected to depreciate. By how much will depend on capital flows to and from India. For instance, earlier in the year, foreign capital continued to flow into India and the rupee did not fall.

The short-run approach to reducing the pressure on the rupee has been to curb imports of gold to lower the current account deficit. Recent evidence suggests two trends. First, official imports of gold have declined. Second, gold smuggling has increased. Government policies to reduce gold imports are aimed at official imports. It is not clear why the government believes that a shift from official channels to smuggling will solve the question of the inflow of gold or its impact on the rupee. It might have the naive faith that total gold imports will go down if restrictions are imposed, and the criminality it introduces into the system is a worthwhile price to pay for reducing the pressure on the rupee. But gold imports are a means of capital flight. If households do not have attractive assets to invest in, if real interest rates on bank deposits are low, if the real estate market is full of black money and scams, gold appears to be an attractive asset for households. Restrictions on gold have not made the rupee stronger.

Ultimately, a currency gets stronger if the economy witnesses higher productivity growth than the rest of the world. During the months that we have been worried about the rupee depreciating, the Chinese yuan has been appreciating. In addition, domestic inflation in China is high and wages are rising. This offers India an opportunity to step in when China inevitably loses its share of foreign markets. But for this, India needs to remove hurdles to the growth of large-scale industry in toys, textiles, engineering goods, household appliances and various consumer durables. This will involve changes in the exit policy of industry, labour laws, policies on foreign direct investment, removal of the infinite obstacles to investment, improving infrastructure such as power, fuel, raw material supply, ports and airports. Addressing these can give us higher productivity growth, which in turn would give us a strong rupee. But these are difficult problems to fix. India has barely begun to understand the problems we face in these sectors. We are far from fixing them. In all probability, we will helplessly watch Bangladesh, Pakistan and Vietnam step into China's shoes.

Today, India can achieve very little export growth through export subsidies or by directly pushing exports, even if the WTO rules allowed that. Most of the problems that stop domestic producers from becoming more productive and export to the world market are policy and infrastructural issues. Until now, our approach has been to boost exports by making policies to help "exporters". That approach needs to change towards policies that lead to an increase in domestic productivity. It is when firms become more productive that they start serving foreign markets. The challenge today is to create an environment in which more firms become productive.

Another element of the reform India needs to undertake urgently is to clean up its foreign investment framework. Today, the framework is so messy that even the government finds it hard to enforce its own rules. The alphabet soup of FDI, FII, FPI, QFI and so forth has no clarity and the legal uncertainty in the system is so high that it manages to turn away even those investors who want to bring money into India.

The time for quick fixes is over. The RBI must be complimented on seeing the problems of trying to implement a peg to the USD back in 2007-08 and moving to a floating exchange rate. Had Subbarao not been wise enough to do that, India would have faced a balance of payments crisis in trying to defend the rupee.