Own goals, broken limbs and band-aids

The desperate interest rate defence won't prevent rupee depreciation but will delay and weaken economic turnaround

It has been anything but a boring summer for Indian policy makers. The preference for a desperate orthodox (IMF-style?) interest rate defence of the rupee hints that they have been feeling the heat despite the cooling effect of a good monsoon. It also suggests that they are running out of lasting, non-disruptive and inexpensive options.

Ironically, in their efforts to lower speculation, supposedly behind the rupee's recent collapse, poor communication and the convoluted implementation have given rise to higher uncertainty across asset classes. Confusing signals from the government and the central bank have only made the actual defence weaker. Frankly, the rupee's poor response to the liquidity squeeze suggests that there wasn't excessive speculation in the first place. In fact, several measures of rupee volatility have jumped again, suggesting the Reserve Bank of India's (RBI's) stated goal of checking volatility remains elusive.

 

Justifying distortionary policy actions on the pretext of checking speculation is a convenient, politically correct approach. How does an exporter who delays converting his proceeds into rupees because of a revised expectation of further rupee depreciation triggered by, say, changes in global factors necessarily become a speculator? Or an importer who rushes to hedge because the basis of rupee stability for some time was fickle hot money debt flows that suddenly reversed.

The fact of the matter is that policy actions in recent years themselves contributed to the risk of higher currency volatility, which has been underpriced. The rupee is on its back because of a double whammy of outsized foreign institutional investor (FII) outflows and rising global crude oil prices in the context of an unsustainably large current account deficit. But this ticking time bomb did not appear overnight. To be sure, the government only increased the vulnerability by greater reliance on risk-driven volatile capital flows that facilitated a false sense of currency stability. Distorting market price discovery and signals are not the way to correct the underlying imbalances.

Unlike Brazil, Turkey and Indonesia, which have all raised policy rates, India has preferred to tighten monetary policy in a roundabout manner. This creates two problems. First, it undermines the RBI's own monetary framework of the repo rate, the rate at which it injects liquidity, being the single policy rate. The whole case of circumventing the existing monetary framework appears to be to avoid signalling that monetary policy has been tightened in a sustained manner.

Second, the key message is lost in translation. The central bank has effectively tightened monetary policy without explicitly saying so. To be sure, government officials and politicians have gone out of their way to try to convince that the easing bias to the monetary policy stance has not changed, and that the RBI could resume cutting rates.

That India's tightening will be temporary and the RBI will cut the repo rate again is wishful thinking. Let us say that the rupee stabilises for some time and, consequently, the RBI eases its liquidity squeeze. Then the US Fed begins its tapering, say, in September or soon thereafter, and global capital flows again have hiccups. Will the RBI re-engineer another liquidity squeeze? A volatile or uncertain policy path and framework only add to uncertainty in asset markets.

The interest rate defence of the rupee could ultimately result in a lose-lose situation. As the central bank "digs in" to defend the rupee with higher interest rates, one of two scenarios will eventually play out. One scenario is that India is prepared to raise short-term rates to, say, 20 per cent, 50 per cent or even higher levels even for a short time to defend the currency, and live with the resulting pain of further collapse in growth. This would be disastrous.

To be sure, the comparison with the late 1990s, when overnight rates had zoomed into the stratosphere to defend the currency, is inappropriate. The damage this time will be significantly greater. At that time India was far less dependent on volatile risk-driven global capital flows. Also, the rupee's problems are partly structural in nature this time, and the global context is very different. At an annual GDP growth of, say, four per cent for India, when cyclical Asian economies will be enjoying accelerating economic growth next year, one will likely hear a loud sound of foreign capital being sucked out.

The second, and more likely, scenario is that after some more fight, policy makers lose their nerve and give up on the interest rate defence. Recall that the government reportedly resisted timely and adequate monetary tightening to fight inflation. Retail inflation is close to 10 per cent and government officials are still talking about monetary easing! In that context, how likely is the government blessing more growth strangulation in the run-up to the next general election?

Irrespective of whether the original idea of an interest rate defence was fathered in Delhi or Mumbai, it is going to be another own goal. It fits in with the approach of misdiagnosis of the economic ills (first the growth slowdown, then inflation, now the rupee) and the use of inappropriate medicine. It also echoes heavy reliance on quick fixes and band-aids (other patches being considered include sovereign, quasi sovereign and non-resident Indian bonds; all three are bad ideas). Unfortunately, structural changes in the real economy remain disappointingly weak.

The cumulative outflow in June and July hit a whopping $10.5 billion. The key concern should be whether policy makers are prepared for another sizeable net outflow of FII capital. The answer has to be a resounding "no".

Investors should brace for more downgrades to GDP growth forecasts, delayed recovery prospects and increased asset quality concerns. Further rupee depreciation is in store even if the currency shows some temporary near-term respite because of another quick fix. The pressure on the rupee from India's high retail inflation differential, diminished growth differential and the adverse impact of the anticipated rebalancing of global capital flows as the US economy gradually heals cannot be wished away.

The rupee's problems are neither new nor temporary; they did not suddenly emerge two months ago. The currency has depreciated around 35 per cent against the US dollar since end-2007. Don't forget that lower rupee volatility doesn't mean it won't depreciate. The rupee is making its way back to the pre-2002 trend of annual depreciation, in my humble opinion. But this adjustment is being resisted, rather than facilitated, by policy makers. Sell the rupee on any rally. It is destined to weaken to 65-70 per US dollar by next year.

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The writer is senior economist at CLSA, Singapore.
These views are personal