Some RBI dos and don'ts

Indian Express, 18th September 2013

It should slash interest rates, stop worrying about inflation or the rupee.

A few weeks ago, in a measure described as temporary, the RBI raised interest rates and tightened liquidity to defend the rupee. Today, interest rates are up to 400 basis points higher than they were in July. These should be reduced immediately, before they are transmitted to higher bank lending rates. That would mean a reversal of the RBI's measures.

Once the short-term steps are reversed, there can be a discussion on monetary policy and on whether the repo rate should be changed. The first argument for cutting rates is forecasts of lower non-food inflation. Demand conditions in the domestic economy are weakening. Not only have consumer and investment demand slumped sharply, the latest quarterly expenditure-based GDP data indicates a demand contraction. It shows a decline of 8.2 per cent in seasonally adjusted private final consumption expenditure, and of 14.2 per cent in gross fixed capital formation. The quality of this data is suspect, so we corroborate it with firm-level data, which also shows a sharp fall in new investment activity. All this points towards a lower non-food inflation forecast, because of declining demand.

However, it may be argued that there could be inflation due to an exchange rate depreciation. One measure of tradeables inflation is the US producer price index multiplied by the rupee-dollar exchange rate. This measure takes into account commodity prices, raw materials for industry, price of output when it can be exported or imported, as well as the exchange rate. Since commodity price inflation is low, it shows that even after including the most recent depreciation, tradeables inflation has fallen sharply. The trend suggests that in coming months, inflation is unlikely to rise significantly because of import inflation.

Most central banks, including the RBI, look at a measure of core inflation to forecast consumer price inflation. It is a measure that captures demand conditions in the economy. Core inflation excludes the most volatile part of inflation, caused by transitory factors that must be excluded while making inflation forecasts. In recent months, core inflation, whether measured by the non-food, non-fuel WPI or the non-food WPI, has declined to below 3 per cent. It has been below 5 per cent for most of 2013, creating confidence that this is not simply a one-off phenomenon. We usually see high persistence in this measure of inflation. It therefore suggests that core inflation is likely to remain low.

The second element in a discussion on the choice of monetary policy is the output gap. While there appears to be a decline in India's potential output, the actual fall in output appears to be much larger. This indicates that there is an increase in the output gap. An increase in demand can expand output even without an increase in capacity. This increase in demand can come from external or internal sources. In our case, there is not much of a case for fiscal expansion, since the deficit is already high and its increase can lead to other difficulties, such as a fall in the country's credit rating. Monetary easing can, however, help increase demand by households and firms.

An additional impact of monetary easing is currency depreciation, which can help increase demand for tradeables. Despite the recent data showing an improvement in exports, there remains a lot of pessimism about the price elasticity of tradeables, both exports and imports, in India today. While it may be true that in the short run the price elasticity of exports and imports is often low, it is rarely zero, and is clearly not positive. A depreciation serves the same purpose as an import duty combined with an export subsidy. As most people will agree, an import duty raises the price of imported goods. A depreciation also does this, across the board and without government interference or an army of customs officers, and without the smuggling and illegality that high duties often bring.

India is now seeing one of the worse declines in production and output. Regardless of the time that an exchange rate change will take to create an adjustment in the current account, the direction needs to be towards a weaker currency. If there existed measures of the real exchange rate which would help identify the precise long-run equilibrium, then at the present stage of the cycle, a weaker currency should be preferred for its expansionary impact.

We finally turn to the question of credibility of the central bank. Since 2008, the RBI has allowed the rupee to float and followed an independent monetary policy. It raised rates, even while the US lowered theirs, in response to domestic business cycle conditions, which then showed that inflation forecasts were higher than its targeted levels. While there was no specific inflation target, and the RBI sometimes made confused speeches about it, there was a shift towards indicating that inflation control was gaining superiority over exchange-rate targeting as the objective of monetary policy.

Earlier this year, in pursuit of monetary policy independence, within the constraints of the trilemma, the RBI indicated that its forecast for inflation and output gap now warranted a cut in interest rates. This was done even though there was a very high likelihood of interest rates rising in the US. The implication was that the RBI, by floating the exchange rate, had now created the space for a monetary policy that could respond to domestic business cycles. The fact that it failed to explicitly state the target, the measure and give up its other objectives appears to have come back to haunt it now. But when Ben Bernanke indicated that he would taper QE, the RBI appears to have lost its nerve. It tightened monetary policy in a needless defence of the rupee and not because domestic business cycle conditions warranted it. But one saving grace was that it was emphasised that the increase in marginal standing facility rates and tightening of borrowing rules on liquidity adjustment facility were only temporary. Undoing these and going back to the path of monetary easing would not undermine the RBI's credibility, but add to it.

The floating exchange rate has worked well for India from 2007 till now. In downturns, the rupee depreciates, and in good times, it appreciates. If we stay on course, the objective of monetary policy will be clear and consistent. In contrast, going back towards an exchange rate policy will raise a whole new set of uncertainties and hurt investment.

The road ahead for Rajan

Financial Express, 5th September 2013

Reserve Bank of India has a new governor, Raghuram Rajan. While Rajan's immediate job would be to determine the stance of monetary policy, and hand out banking licences, as RBI Governor for the next five years, his main task must be to transform RBI into a modern central bank.

The task of transforming RBI into a modern central bank consists of redefining the mandate of the central bank and its functions, clearly defining the objective of monetary policy and institutions related to conduct of monetary policy, and redesigning the role of RBI as a banking regulator.

These issues have been raised by a number of official committees, including the one headed by Rajan himself. Most recently, the Financial Sector Legislative Reforms Commission (FSLRC) made its recommendations. It has three major implications for RBI. First, the central bank should be a regulator only of banking and payments and the monetary authority. Second, the regulatory governance for regulation has to be significantly improved. Third, the objective of monetary policy should be clearly defined.

According to the FSLRC, RBI should have independence and accountability. It should set up a statutory monetary policy committee with powers to take decisions on monetary policy, unlike the present one that is advisory and where decisions are taken by the Governor, who is open to pressure from the ministry of finance. In addition, it recommended that RBI should give up some of its present functions such as those of the government's debt manager, the regulator of markets for securities such as government bonds, currencies and interest rate derivatives, of capital controls and of non-bank financial intermediaries.

Decisions about issues of regulatory architecture and governance would be made by the government. It involves decisions not just about RBI but other regulators as well. The most important task for Rajan will be to help define the objective and functioning of monetary policy.

The fall of the rupee has highlighted India's high inflation. In the last five years, under Governor D Subbarao the rupee was largely allowed to float. However, though policy shifted away from a pegged exchange rate to a floating exchange rate, monetary policy was left unanchored. There was no clear and well defined nominal anchor that could guide price expectations. Though the floating exchange rate gave RBI the opportunity to have an independent monetary policy, by failing to define the objective of monetary policy, and given RBI's multiple other objectives, the rupee was left unanchored. Worse, on a number of occasions, the central bank argued that inflation control was not the main objective of monetary policy.

RBI's commitment to inflation control has been episodic. Some governors like C Rangarajan believed that it was the main job of monetary policy, others like YV Reddy focussed on the exchange rate as the nominal anchor. Even though in the last 5 years there seemed to be some effort at price control, India has now witnessed years of consumer price inflation between 8-10%. In recent surveys, inflationary expectations of households have risen above 10%. The rising demand for gold is another indication of higher inflationary expectations.

The FSLRC has suggested that the RBI Act of 1934 be repealed and a new law more suitable for a modern central bank replace it. In most advanced economies, especially those with recent monetary policy laws, the objectives of monetary policy are contained in the law. The Commission has left it to the government to define what the objective should be. The law is proposed to only say that it will be a measurable nominal objective for which RBI will be held accountable. So, it could be an inflation rate, a price level, nominal GDP or even the level of the rupee.

In the consultations on the proposed Indian Financial Code, Rajan's role is to discuss whether FSLRC's proposal is a suitable proposition or whether the objective of the policy should be written down in the law. The present formulation in IFC is a non-standard one. The new Governor's job is to help the ministry of finance choose the best nominal anchor and, preferably, write it in the law.

His second task would be the constitution of the monetary policy committee (MPC), where again the IFC has a non-standard formulation. One plausible alternative composition, somewhat similar to the Bank of England, might be to have four members, from inside the central bank, including the governor, and three independent experts from outside who bring in diverse views. These members would then vote to choose whether the repo rate should be raised or lowered. Their individual voting stance would have to be justified and made public to prevent them from either being quiet yes-men or from being unnecessarily contrarian. Rajan will have to work hard on building a well functioning MPC.

Coming to the here-and-now, the stance of monetary policy is no doubt going to involve difficult decisions. The economy is faced with a stagflation. It would have been much simpler for him if it was either high growth and high inflation, or low growth and low inflation. Standard rules of monetary policy could have been easily used. To make matters worse for inflation the rupee is under acute pressure and monetary easing would increase the pressure.

The trade-offs are difficult. Ultimately, the only instrument in RBI's hands is the interest rate. While RBI may sometimes try changes to the CRR, sometimes foreign exchange intervention or sale and purchase of government bonds, or changes to some specific interest rates, ultimately it is bank interest rate that will be impacted and affect firms and households. As demonstrated in the last few weeks, trying to address these multiple objectives with a single instrument is impossible. Rajan will have to find the right balance between his emphasis on growth, inflation and the rupee, and choose whether to raise rates or lower them. There are no simple answers.

Fighting the taper

Indian Express, 3rd September 2013

Volatility is inevitable. India should prepare its response to the winding up of QE

The dominant theme at the annual meeting of central bankers and economists last week at Jackson Hole, Wyoming, was the impact of Quantitative Easing (QE) tapering on emerging markets (EM). Central bankers from emerging economies pressed Fed officials to consider the volatility in emerging economies arising from changes in the Fed's monetary policy stance. But Fed officials reminded them that their mandate was only to serve the US economy. Emerging markets would have to adjust.

Knowing that the world will be a more volatile place gives us time to prepare. India's policy response to QE tapering should be prepared in advance so that we do not see more of the kind of knee-jerk reactions that were seen last month. It is expected that September may see more forward guidance by the Fed, rather than actual tapering. The pace and timing of the tapering are likely to remain uncertain for many months. This could result in huge volatility in global financial markets. One important question for India will be whether to respond to the pressure on the currency and if so, how.

First, let us look at what lies ahead. The objective of the US Fed's monetary policy is to maintain price stability and achieve maximum employment. The Federal Open Market Committee is responsible for taking decisions on how to achieve these objectives. In normal times, this was done by cutting or raising the policy interest rate. On December 16, 2008 the policy interest rate was cut to the lowest possible level of 0-0.25 per cent. After this, there was no scope of cutting interest rates and the Fed eased monetary policy by purchasing financial assets, thereby stimulating growth, popularly known as QE. The Fed announced its first round of purchases in November 2008 and started buying bonds from March 2009. There have subsequently been two more rounds of QE, in 2010 and then in 2012, as the US economy did not show signs of recovery. The Fed is currently buying $40 billion of Mortgage Backed Securities and $45 billion worth of US treasury bonds per month. Tapering refers to a reduction in the purchase of such securities by the US Fed.

The US economy has recovered slowly in the first half of 2013, with the recovery expected to be faster in the second half. In Q2 2013, the US economy grew at 1.7 per cent. Growth in Q3 and Q4 is expected to be 2.5 per cent. Inflation is around the desired level of 2 per cent. The unemployment rate has fallen from 7.9 per cent at the beginning of the year to 7.4 per cent in July. The Fed has indicated that after the unemployment rate reaches 6.5 per cent, it may consider reducing the pace of its balancesheet expansion.

However, even though the Fed has indicated that it could reduce the pace of monetary expansion, an unemployment rate of 6.5 per cent will not trigger the tapering. One reason is that the US unemployment rate is falling not so much because jobs are increasing, but because of lower labour force participation. Less people say they are actively looking for jobs, something that is likely caused by the long recession. The Fed remains worried that merely a lower unemployment rate may not signal a healthier economy.

Even if the tapering starts in the next couple of months, it will only be the beginning of the process. There will be a reduction in purchases, then stopping purchases and later, at some point, sales of treasuries to reduce the size of the Fed balancesheet to tighten monetary policy. For the last five years, when the Fed was expanding its balancesheet, there was a large flow of capital to emerging economies in search for higher returns. Now the prospect of higher US interest rates is attracting capital back to the US. The top 20 traded EM currencies have depreciated on average 6.8 per cent since May 1, 2013. The depreciation has been most pronounced for countries which need more dollar inflows on the capital account to finance their current account deficits. The currencies of South Africa, India and Brazil have fallen more than 15 per cent against the dollar since May 1, 2013.

Looking forward, the markets may see more capital flow volatility. Flows respond to the probability of the timing and speed of QE tapering, which is estimated by market participants depending on their forecasts about the US economy. When US data is different from these forecasts, this probability changes. This results in inflows and outflows to the US, especially from EMs. This causes high volatility in EM currencies and markets. The data to watch for are those for US jobs growth, labour force participation, inflation, mortgage rates and new home sales, among others.

In August, in the face of acute pressure on the rupee, the government and the RBI valiantly tried to defend it, and reduce the current account deficit. They succeeded only in raising interest rates, increasing capital controls, encouraging gold smuggling, distorting financial markets, creating panic and damaging their respective reputations. Instead of silly policies like duties on flat screen TVs or restricting petrol pump timings to 8am to 8pm, as Veerappa Moily had proposed, the government needs to think carefully about its strategy.

Changing the economy's fundamental weaknesses overnight is nearly impossible. The weaker rupee is, however, good both for current account adjustment and for making Indian assets more competitive. Less friction for foreigners who invest in financial markets should be part of the strategy. It is also very important not to send out wrong signals. Only those short-term policies should be proposed that are consistent with longer term objectives of growth, global integration, rule of law and better financial regulation. The entire cabinet, all ministries, regulators and the bureaucracy must be on the same page about the government's decision to attract foreign capital so that innumerable unnecessary restrictions that are being placed today on foreign investors can be removed. The government must prepare a carefully coordinated, coherent and consistent action plan to adjust to the QE tapering and resulting volatility.

Reform chance for new Indian governor

OMFIF, 30th August 2013

Rupee's fall could spur new monetary initiatives

Raghuram Rajan, the new governor of the Reserve Bank of India, can turn the crisis engendered by the rupee's fall into an opportunity to reform the objectives and the instruments of Indian monetary policy.

A Government of India committee, the Financial Sector Legislative Reforms Commission, has recently suggested that the RBI Act of 1934 be repealed and replaced with a new law more suitable for a modern central bank. Anchoring expectations on inflation would require narrowing the objectives of monetary policy and bringing in financial sector reforms that can strengthen the presently weak transmission mechanism of monetary policy.

The Indian rupee has seen one of the sharpest falls in recent times. Although the path ahead is not easy, reforms that have been delayed in the past are now manifestly necessary. Indians have to recognise that there are structural reasons behind the behaviour of the rupee that go beyond the decline in GDP growth and the large current account deficit.

After the 2008 crisis the currency was largely allowed to float, but the move from a pegged exchange rate was not accompanied by a well-defined nominal anchor that could guide price expectations. Though a floating exchange rate facilitated an independent monetary policy, the policy objective was not clearly articulated.

On a number of occasions the RBI argued that price stability or an inflation target could not be its sole or even main policy objective. The RBI preferred the approach of following multiple objectives.

India has now seen nearly seven years of 8-10% consumer price inflation, higher than RBI's target rate of 4-5%. In recent surveys, inflationary expectations of households have risen to above 10%. The demand for gold, which is largely imported, has risen as households have attempted to hedge inflation, putting pressure on the current account. These imports are effectively capital flight from India. All these factors increase the sense of crisis - but monetary reforms may now rise higher up the policy agenda than would otherwise be the case. The new governor has the chance to show his mettle.

The needless battle

Indian Express, 19th August 2013

Rupee defence strategy has deepened the gathering gloom on the India growth story.

The defence of the rupee is going horribly wrong. It has damaged two sources of hope for a growth pick-up in India - monetary policy easing and India's commitment to economic reform. When Chairman Ben Bernanke of the Fed talked about tapering quantitative easing in the US, it was expected that there would be pressure on emerging market currencies. Countries with weaker economies, and with larger current account deficits were likely to see more currency volatility. Instead of talking about this source of pressure, which all emerging markets faced when the dollar started appreciating, the government decided to step in to defend the rupee.

Evidence from across the world shows that a currency defence often fails. Every government trying to stabilise a currency is, therefore, fully aware of the chances of failure. A careful cost-benefit analysis of its strategy is thus an important pre-condition to initiating a defence. Since the global currency turmoil started, the government has been rolling out measures such as currency market controls, import duties on gold and silver, bans on purchase of gold coins and tightening of capital controls to stabilise the rupee. These dirigiste solutions seem oblivious of their likely impact on market expectations. They are based on central planning notions of bans and restrictions being the solutions to the economy's problems.

First came restrictions on currency derivatives markets by Sebi and the RBI. These markets inform people of expectations about the currency. This information may be unpleasant. The government may disagree with it. But instead of listening to what the market was saying, the authorities chose to try to silence it. Restrictions reduced the extent to which people could hedge their currency risk. This was a bad move, especially since the rupee was expected to become more volatile. It made investors less willing to buy rupee assets. Trading volumes on domestic currency derivatives markets fell sharply and the cost of hedging increased. Instead of making rupee assets more attractive, these measures have made them less attractive. Further, the restrictions have undermined the market's confidence about the government's commitment to financial market liberalisation.

Next came the liquidity squeeze and an increase in short-term interest rates. The complicated strategy hoped to keep long-term interest rates low. This, too, failed. When the rate hike saw a transmission of higher rates to treasury bill rates, long-term bond yields and deposit rates, it became increasingly clear that sooner or later bank lending rates would go up. To prevent that, the RBI kept the repo and CRR rate unchanged. This left the market in complete confusion. Were interest rates going to rise or fall? Statements by the authorities that the tightening was temporary till the rupee stabilises provided little comfort. Could the currency stabilise before US monetary policy went back to normal? How long was "temporary"? In an environment in which a monetary easing was expected to help push up growth, this sudden tightening was a shock. Interest rates are still high. The measures have undermined confidence about monetary policy easing.

After the liquidity squeeze failed to restore rupee stability, came tariff hikes and restrictions on gold and silver imports and tightening of capital controls under FEMA. Restrictions have been imposed on capital outflows by firms and households. Already, firms were suffering from the difficulties of the policy environment. If some of them were going to stay healthy by investing abroad, that was made more cumbersome. Hardly any money was going out by individuals investing abroad. But putting a restriction on these trickles sent out a bad signal to an already nervous market. These measures did not inspire confidence that the government's focus was investment and growth. Worse, they suggested that India's economic reforms are not deep-seated and can be reversed for short-term ends.

With the opening up of trade and the capital account, the currency market has grown very large. Old solutions, like selling a few billion dollars from our reserves to prevent appreciation, no longer work. Out of the three corners of the impossible trinity, a country can choose only two. For the last two decades, India had chosen to move towards an open economy and a flexible exchange rate. In the face of the QE tapering, it means choosing between rupee stability and lowering interest rates. But the government did not like having to make the choice. It wanted both. The only way to control the currency in such a situation is to close the economy. When the size of the market has shrunk adequately, the RBI can intervene and prevent depreciation without much loss of reserves.

If the rupee remains volatile, the government has to choose to either roll out the next measure it has on its list, or to find an exit route. FEMA allows the RBI and government to shut off all cross-border transactions for sale and purchase of assets. The market believes that as long at the rupee defence strategy remains in place, the authorities might impose restrictions on various other capital flows. This expectation has caused further gloom.

We should not lose sight of the big picture of Indian economic policy. The story of the last 20 years is one of slow but steady economic reform resulting in 7 per cent trend GDP growth. The day we walk away from the promise of slow but steady reform, the expectation of future productivity growth is shattered. This adversely affects the credit rating of India, stock prices, investment in India by locals and by foreigners, and capital flight from India. The needless battle the government has picked on the rupee, and the measures it has taken, have reinforced the already growing despondence about economic reforms. It has raised new questions on the India growth story. The government must immediately undo all the steps that have reversed economic reforms of trade or finance or capital account liberalisation. Otherwise, we will suffer deeper damage to the prospect of high GDP growth.

India Inc hedges its bets

Financial Express, 16th August 2013

Indian companies have borrowed heavily abroad, attracted by low interest rates. It is feared that a depreciation of the rupee will hurt corporate balance sheets adversely and make the economic situation worse. Measurement of firm currency exposure shows that, fortunately, this is not the case. All large and medium sized Indian companies, who are usually the ones who borrow in dollars, expected rupee depreciation. Most of them have hedged their currency exposure. This is not surprising considering the large current account deficit, the slowing economy, higher inflation and the expected increase in US interest rates coupled with the last few years of RBI's policy of not intervening in the rupee-dollar market.

Some exporters have a natural currency hedge when they borrow, some companies chose not to borrow abroad, while still others hedged in the derivatives markets. This behaviour is perfectly rational. If a depreciation was expected, it made little sense for a company to take a dollar loan, even if it was cheaper, whose payment would become more difficult in a couple of years.

Table 1:

	Gain from Appreciation	Neutral	Gain from Depreciation
2002-2004	300	1539	17
2011-2013	0	1201	81

Source: Author's calculations

Table 2:

Firms borrowing abroad		(March 2012)
Total number of firms:		8382
Firms borrowing abroad:		843
Amount borrowed abroad:		USD 236.66 billion

Source: Prowess, CMIE.

The data for firms borrowing abroad is available in the CMIE prowess data base. We see that in March 2012, out of 8,382 companies, only 843 companies, or 10% of all Indian firms, borrowed abroad. The data suggests that today also the figure should be roughly the same. However, exposure may arise in many other ways as well. For example, if a firm imports raw materials, but cannot pass on the increase in costs, its profit margins would decline.

Figure 1: External commercial borrowings (per month)

Hence we measure unhedged currency exposure of Indian firms. This measure uses an analysis involving daily stock market and currency data and, therefore, can be estimated till end July 2013. It measures whether the company loses or gains in value when the rupee-dollar rate moves, or the average impact of a 1% currency depreciation on the stock price. If the firm has hedged, then the stock price does not gain or lose value when the currency moves. We measure exposure for 1,282 of the listed firms that have fairly adequate liquidity.

First, we look back at the 2002-04 period. Here, there was large-scale trading by RBI on the currency market aiming to prevent rupee appreciation. Most market participants expected the rupee to appreciate. At this time, it was advantageous for firms to set themselves up to profit from the expected future appreciation by invoicing in rupees, hedging export proceeds, leaving imports unhedged, borrowing in dollars, etc. Our analysis shows that there were 300 large firms who had positioned themselves to gain from appreciation. There were 1,539 firms who did not have a statistically significant exposure. There were only 17 firms who did not expect an appreciation and would be hurt by it.

If, in that situation, a sudden and unexpected depreciation had taken place, it would have generated a substantial adverse impact upon these 300 firms who were betting on appreciation.

Then we turn to the latest two years ending in July 2013. Our analysis shows that there are no firms who have set themselves up to gain from appreciation. There are 1,201 firms who have no statistically significant exposure. There are 81 firms which stand to gain from depreciation. These are firms who would have invoiced in dollars, left exports unhedged, hedged imports, and not borrowed in dollars. Most firms were hedged. There was not a single firm who was expecting a rupee appreciation and took positions accordingly. The unhedged exposure, though little, is on the other side.

There is, of course, nothing really surprising in this. Few observers of the Indian economy were expecting a strong or stable currency. When the exchange rate is managed, firms have an incentive to throw caution to the winds. As long as the firm does not have to pay the hedging costs itself, it is always cheaper to borrow in dollars. In the past when the rupee-dollar exchange rate was kept stable, firms left their currency exposure unhedged.

This has two implications. First, firms take on more currency risk under a managed exchange rate. In 2002-04, there were 317 firms who were betting on exchange rate fluctuations. The floating exchange rate, which has prevailed from March 23, 2007, onwards, has induced fear in firms and fewer firms are leaving their currency exposure unhedged.

The second important implication is that at present rupee depreciation does not have an adverse impact for big and medium sized Indian firms that constitute the dataset. There are 81 firms who will actually gain from a large rupee depreciation. There are no firms who stand to lose from a rupee depreciation.

However, there are a large number of firms with interest rate exposure. These are firms who have borrowed domestically and expected an easing of monetary policy. These firms are much large in number. In fact, almost every firm has some borrowing. This borrowing is largely unhedged as there are few ways to hedge it in Indian markets today.

Monetary policy in an open economy involves making a choice between ensuring low currency volatility or ensuring low interest rate volatility. In both 2002-04 and in the last two weeks RBI intervened to provide low currency volatility. In this choice between currency volatility and interest rate volatility, most firms today would have a preference for higher currency volatility rather than interest rate volatility.

Looking forward, these episodes have important policy implications. Countries have experienced acute distress when a large part of the corporate sector had a certain bet (for example, betting on rupee depreciation) and things suddenly went the other way. It is good for India if firms are hedged. It makes the economy more resilient.

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.