RBI risks its credibility to save the falling rupee
RBI pushes up interest rates to protect the rupee but tries to sidestep the consequences. With the rupee moving largely in one direction, the RBI seemed to
believe this was a low risk opportunity exploited by the financial
sector.
RBI Governor D Subbarao <em>Photo : Nishikant Gamre</em>
About seven weeks before he was to finish his five-year term as the Reserve Bank of India's 22nd governor, D. Subbarao made a hasty trip from Mumbai to New Delhi on July 15.
Subbarao met Finance Minister P.Chidambaram. It was a meeting held against the backdrop of weeks of turmoil in the foreign exchange market as the rupee consistently depreciated against the US dollar, breaching a psychologically crucial barrier of Rs 60 in early July.
There seemed no end to the rupee's slide. A couple of days before Subbarao's visit, Raghuram G. Rajan, the finance ministry's Chief Economic Advisor and tipped as a possible successor to the governor, did some loud thinking about another psychological barrier. At a public function, Rajan said that some analysts' forecast that the rupee would dip to Rs 70 a dollar was not supported by rigorous analysis. The surprise was that a senior finance ministry official publicly talked about a level that seemed inconceivable even a few months ago.
A few hours after Subbarao's meeting with Chidambaram and after the markets had closed for the day, came a set of moves by the RBI to defend the rupee. A brief press release said the RBI was, overnight, going to upend 18 months of monetary easing. It was a policy reversal which suggested that growth, at a decadal low, was no longer top priority. According to D.K. Srivastava, Chief Policy Advisor, EY, the move indicated that now financial stability was.
The RBI tried to squeeze money supply, or liquidity, and push up the short-term interest rate . The tool used was a cap of Rs 75,000 crore on the extent banks could borrow from the RBI to cover a shortfall in funds. The aim was to choke the flow of money raised at low interest in the domestic money market and deploy it in taking positions on the rupee. With the rupee moving largely in one direction, the RBI seemed to believe this was a low risk opportunity exploited by the financial sector.
Indeed, the rupee's slide - it had closed at Rs 54.69 on January 1 - to a level below Rs 60 in early July has undone the hard-earned economic gains of a year. The most striking gain was that Chidambaram, by relentlessly focusing on trimming government expenditure, had brought down the fiscal deficit (the excess of expense over income) to 4.9 per cent of gross domestic product (GDP) in 2012/13, outperforming market expectations.
The control over fiscal deficit was complemented by the RBI paring interest rates three times in 2013, as it tried to catalyse an investment revival to boost economic growth that had fallen to a decade's low of five per cent in 2012/13. The performance impressed credit rating agency Fitch enough to upgrade India's outlook from negative to stable.
Now, the rupee's slide threatened it all, defeating the government's attempt to curb fuel subsidies. What started towards the end of May as a global flight of capital from emerging markets on fears that the US monetary stimulus would soon end, shook the Indian economy on account of its vulnerable economic indicators.
India's current account deficit (excess of imports over exports and remittances that needs to be covered by foreign inflows) in 2012/13 was 4.8 per cent of GDP, or $87.8 billion, way above the 2.5 per cent the RBI considers sustainable. To this mix, add the growing market perception that the RBI was not going to defend the rupee, and the result was a slide in the currency that showed no signs of stopping."I think RBI acted also because there were clearly speculative positions built up offshore," says Naina Lal Kidwai, Group General Manager and Country Head, HSBC India, explaining that positions in derivative markets on the rupee in places such as Dubai and Singapore may have put downward pressure on the currency.
Chief Economic Advisor Rajan said something similar a day after the RBI's move. "Raising the cost of speculating," was his succinct description of what the RBI's move implied. Making speculation costly is one thing. But it is difficult to understand why the RBI would want to make even investment costly at a time of low growth. "It (RBI) was trying to re-anchor the exchange rate," says Renu Kohli, an independent economic consultant, who was earlier a staffer at the RBI and the International Monetary Fund.
Using interest rates to defend the currency is not new. Indonesia and Brazil did so a little before the RBI but India's context is different. Rajan feels growth tends to "paper over" a lot of problems. If growth is undermined, will the economy's fault lines show up more sharply?
Within three days of the July 15 move, the extent to which the RBI had risked its credibility to defend the rupee became apparent.
The RBI wants to raise the cost of short-term interest rates, but keep the long-term rate down in order to encourage investment. The first sign came on July 18. The central bank conducted an open market operation (selling government securities to suck money out of the market) for Rs 12,000 crore. Eventually, only Rs 2,532 crore of long-term securities were sold as the market refused to settle for lower interest rates. The attempt to nudge up short-term rates had begun to put pressure on long-term rates also.
"Now, the only hope is the monsoon," says Samiran Chakraborty, Managing Director, Regional Head of Research, Standard Chartered Bank. According to Chakraborty, RBI's strategy of using interest rates to defend the rupee had removed the possibility of an investment revival.
As the week drew to a close, the first set of downgrades of growth rates began to trickle in as analysts factored in the negative impact of higher interest rates.
Macquarie marked down its 2013/14 growth forecast from 6.2 per cent to 5.3 per cent. Deutsche Bank, on its part, knocked off a percentage point from its forecast and said it expected the economy to grow five per cent in the current financial year. Prime Minister Manmohan Singh, a former RBI governor himself, tried to soothe markets and explain that July 15 did not mean a reversal of the trend of softening interest rates, but conceded that economic growth might be lower than expected earlier. "We had targeted 6.5 per cent growth at the time the Budget was presented but it looks as if it will be lower than that," Singh said, addressing an industry gathering.
Market expectations, too, began to harden.
On July 23, the RBI was forced to announce another set of measures to choke money supply to defend the rupee. This time the guidelines to measure Cash Reserve Ratio - the amount banks have to keep with the RBI - were tweaked, but the ratio remained unchanged. Once again, the cost of money was raised indirectly. Interest rates, meanwhile, have hardened. The yield on 10-year government paper on July 23 was 8.17 per cent, compared with 7.46 per cent at the end of June.
The RBI's strategy of indirectly nudging rates higher by squeezing money supply came in for criticism from Pratip Chaudhuri, Chairman of State Bank of India, India's largest lender. "If the central bank decides to press the button, it should do it in a more open and transparent way," he told the media.
The combined impact of the RBI's measures served to halt the slide in the rupee for the moment. The rupee closed at Rs 59.11 against the dollar on July 25, an appreciation from Rs 59.89 when the RBI unleashed its liquidity choking measures.
"The general feeling is that the rupee is slated to depreciate even more," is EY advisor Srivastava's gloomy prognosis. "This may not work (and) eventually the rupee will keep sliding," he adds.
When will the RBI roll back its measures? The RBI has chosen to stay silent on the subject. And if the rupee's slide starts once the measures are withdrawn, will the price have been worth it?
India's macroeconomic woes threaten to besmirch the reputation of the one institution that has often provided a sense of hope.
Subbarao met Finance Minister P.Chidambaram. It was a meeting held against the backdrop of weeks of turmoil in the foreign exchange market as the rupee consistently depreciated against the US dollar, breaching a psychologically crucial barrier of Rs 60 in early July.
There seemed no end to the rupee's slide. A couple of days before Subbarao's visit, Raghuram G. Rajan, the finance ministry's Chief Economic Advisor and tipped as a possible successor to the governor, did some loud thinking about another psychological barrier. At a public function, Rajan said that some analysts' forecast that the rupee would dip to Rs 70 a dollar was not supported by rigorous analysis. The surprise was that a senior finance ministry official publicly talked about a level that seemed inconceivable even a few months ago.
The RBI tried to squeeze money supply, or liquidity, and push up the short-term interest rate . The tool used was a cap of Rs 75,000 crore on the extent banks could borrow from the RBI to cover a shortfall in funds. The aim was to choke the flow of money raised at low interest in the domestic money market and deploy it in taking positions on the rupee. With the rupee moving largely in one direction, the RBI seemed to believe this was a low risk opportunity exploited by the financial sector.
Indeed, the rupee's slide - it had closed at Rs 54.69 on January 1 - to a level below Rs 60 in early July has undone the hard-earned economic gains of a year. The most striking gain was that Chidambaram, by relentlessly focusing on trimming government expenditure, had brought down the fiscal deficit (the excess of expense over income) to 4.9 per cent of gross domestic product (GDP) in 2012/13, outperforming market expectations.
The control over fiscal deficit was complemented by the RBI paring interest rates three times in 2013, as it tried to catalyse an investment revival to boost economic growth that had fallen to a decade's low of five per cent in 2012/13. The performance impressed credit rating agency Fitch enough to upgrade India's outlook from negative to stable.
Now, the rupee's slide threatened it all, defeating the government's attempt to curb fuel subsidies. What started towards the end of May as a global flight of capital from emerging markets on fears that the US monetary stimulus would soon end, shook the Indian economy on account of its vulnerable economic indicators.
India's current account deficit (excess of imports over exports and remittances that needs to be covered by foreign inflows) in 2012/13 was 4.8 per cent of GDP, or $87.8 billion, way above the 2.5 per cent the RBI considers sustainable. To this mix, add the growing market perception that the RBI was not going to defend the rupee, and the result was a slide in the currency that showed no signs of stopping."I think RBI acted also because there were clearly speculative positions built up offshore," says Naina Lal Kidwai, Group General Manager and Country Head, HSBC India, explaining that positions in derivative markets on the rupee in places such as Dubai and Singapore may have put downward pressure on the currency.
Chief Economic Advisor Rajan said something similar a day after the RBI's move. "Raising the cost of speculating," was his succinct description of what the RBI's move implied. Making speculation costly is one thing. But it is difficult to understand why the RBI would want to make even investment costly at a time of low growth. "It (RBI) was trying to re-anchor the exchange rate," says Renu Kohli, an independent economic consultant, who was earlier a staffer at the RBI and the International Monetary Fund.
Using interest rates to defend the currency is not new. Indonesia and Brazil did so a little before the RBI but India's context is different. Rajan feels growth tends to "paper over" a lot of problems. If growth is undermined, will the economy's fault lines show up more sharply?
Within three days of the July 15 move, the extent to which the RBI had risked its credibility to defend the rupee became apparent.
The RBI wants to raise the cost of short-term interest rates, but keep the long-term rate down in order to encourage investment. The first sign came on July 18. The central bank conducted an open market operation (selling government securities to suck money out of the market) for Rs 12,000 crore. Eventually, only Rs 2,532 crore of long-term securities were sold as the market refused to settle for lower interest rates. The attempt to nudge up short-term rates had begun to put pressure on long-term rates also.
"Now, the only hope is the monsoon," says Samiran Chakraborty, Managing Director, Regional Head of Research, Standard Chartered Bank. According to Chakraborty, RBI's strategy of using interest rates to defend the rupee had removed the possibility of an investment revival.
If the central bank decides to press the button (hike interest rates), it should do so in a more open and transparent way: Pratip Chaudhuri, Chairman, State Bank of India
Macquarie marked down its 2013/14 growth forecast from 6.2 per cent to 5.3 per cent. Deutsche Bank, on its part, knocked off a percentage point from its forecast and said it expected the economy to grow five per cent in the current financial year. Prime Minister Manmohan Singh, a former RBI governor himself, tried to soothe markets and explain that July 15 did not mean a reversal of the trend of softening interest rates, but conceded that economic growth might be lower than expected earlier. "We had targeted 6.5 per cent growth at the time the Budget was presented but it looks as if it will be lower than that," Singh said, addressing an industry gathering.
Market expectations, too, began to harden.
On July 23, the RBI was forced to announce another set of measures to choke money supply to defend the rupee. This time the guidelines to measure Cash Reserve Ratio - the amount banks have to keep with the RBI - were tweaked, but the ratio remained unchanged. Once again, the cost of money was raised indirectly. Interest rates, meanwhile, have hardened. The yield on 10-year government paper on July 23 was 8.17 per cent, compared with 7.46 per cent at the end of June.
The RBI's strategy of indirectly nudging rates higher by squeezing money supply came in for criticism from Pratip Chaudhuri, Chairman of State Bank of India, India's largest lender. "If the central bank decides to press the button, it should do it in a more open and transparent way," he told the media.
We had targeted 6.5% growth at the time the Budget was presented but it looks as if it will be lower than that: Manmohan Singh, Prime Minister
"The general feeling is that the rupee is slated to depreciate even more," is EY advisor Srivastava's gloomy prognosis. "This may not work (and) eventually the rupee will keep sliding," he adds.
When will the RBI roll back its measures? The RBI has chosen to stay silent on the subject. And if the rupee's slide starts once the measures are withdrawn, will the price have been worth it?
India's macroeconomic woes threaten to besmirch the reputation of the one institution that has often provided a sense of hope.
