Raghuram Rajan takes helm at difficult time

OMFIF, 7th August 2013

Failed rupee defence creates formidable challenge for new India governor

The new governor-designate of the Reserve Bank of India (RBI), Raghuram Rajan, faces a formidable set of challenges: falling Indian growth, rising financial market interest rates and doubts whether the authorities have the will and the instruments to defend the plunging rupee.

Rajan, currently the Finance Ministry's chief economic adviser and honorary economic advisor to Prime Minister Manmohan Singh, has an enviable reputation as a former chief economist at the International Monetary Fund and the man who predicted the 2007-08 financial crisis. His appointment to replace Duvvuri Subbarao in early September comes at a crucial time.

The US Fed's moves towards tapering off its quantitative easing (QE) bond purchases have led to problems for the currencies of many emerging market economies with large current account deficits, but nowhere has the fall-out been greater than India. Having earlier held up well in comparison to other currencies (such as Turkey, South Africa and Brazil), the rupee has come under heavy pressure in the last two months.

The Indian authorities have reacted to the sharp depreciation by implementing a host of measures including engineering higher bank interest rates through a liquidity squeeze on the banking system, and imposing regulations that reduce participation in currency derivatives markets. However, the RBI has pointedly left unchanged its official interest rates.

Measures to reduce anti-rupee speculation have been ineffective, with the currency falling below the Rs 60 per dollar level that the authorities sought in the past to defend.

There is considerable confusion in the market. Will the RBI defend the rupee with further tightening and capital controls? When will it reverse its measures? One of the most difficult issues that the new governor faces is that many observers believe that the RBI's rupee policy, its implications for the domestic market, and the exit strategy were not well thought out in the first place.

The failed defence of the rupee has exposed clear policy shortcomings including lack of transparency and interference in financial markets. All this will be very costly for India. The governor-designate has pointedly said he has 'no magic wand' to resolve these problems. Nevertheless, expectations on him to make the right decisions are very high.

Since the 2008 crisis, the Indian exchange rate policy has, in general, been to allow the rupee to depreciate. First, this was because the fall in the rupee mainly reflected the dollar's appreciation, so there was little India could do about it.

Second, the depreciation was useful as it could help correct the large current account deficit. It kept the real exchange rate from appreciating as India has a higher inflation rate (at about 8-10%, measured by consumer price inflation) than its main trading partners.

Third, the RBI holds about $280bn of foreign reserves. This comfortably covers six months of imports, but would be insufficient if the RBI started to sell, say, $8-10bn a day to defend the rupee.

Fourth, increasing the RBI's official benchmark lending rates was considered inappropriate as the Indian economy has been slowing down, investment sentiment is weak and - even though inflation is higher than the authorities would like - price rises are starting to abate given the sharp deceleration in demand.

Why did the RBI react so strongly this time? The rationale for the sudden sharp defence of the rupee at Rs60 remains a mystery. Unlike the Indian government, many Indian companies have a large external debt. Defending their balance sheets could have been the ostensible reason to defend the rupee. In reality, however, most of these corporates expected a rupee depreciation and were hedged beforehand. An alternative reason could have been the fear of further inflation. However, this cannot be a strong justification, as core inflation is now below the levels reached in the last five years when the RBI didn't react.

The RBI started easing monetary policy in the beginning of 2013, but last month saw a sudden change as the rupee was seen to be too volatile. The RBI's action to protect the rupee did not include raising the repo rate or the cash reserve ratio, which have been the main tools of monetary policy in the last decade. Its flurry of actions led to a sharp rise in the overnight call money rate, the Treasury bill rate and the 10-year government bond yield. Auctions of government bonds failed, as the RBI failed to meet investors' yield expectations.

The RBI's decision to leave the repo rate and the cash reserve ratio unchanged has been a bid to persuade the domestic market that liquidity tightening was only temporary. The financial markets viewed this as a signal that monetary tightening would soon be reversed. The rupee depreciated further and the RBI and state-owned banks are now reported to be selling dollars.

The lack of rupee recovery has resulted in a wedge between the onshore and the large offshore (non-deliverable forwards) market for the rupee, a very tight domestic liquidity situation, higher deposit rates by some private sector banks and a further loss of confidence in Indian policy-making.