Currency markets are overshooting a little bit: Leif Eskesen

At a time when the Indian economy is facing its worst crisis in a decade, not many would suggest a tighter monetary policy. Leif Eskesen, Chief Economist for India and ASEAN at HSBC Global Research, wants the Reserve Bank of India to do just that. In an interview with Suveen K. Sinha, Eskesen also talks about the rupee's slump and why a full-blown currency crisis is unlikely. Edited excerpts:

Q. Prime Minister Manmohan Singh has said in Parliament that there will be no return of capital controls. How do you react to that?
A. That is a positive. At a time when there is nervousness in markets, you have to be careful about even hinting at capital controls being a possibility. It is a good message to send to foreign investors, that they have nothing to worry about on that front. If they thought it was a possibility, it could potentially lead to more adverse capital flow dynamics. Capital outflows could have been exacerbated.

Q. Duvvuri Subbarao , former governor of the Reserve Bank of India, had said that according to the Indian government the market had been misbehaving. According to Subbarao, we do not understand the behaviour of the market. Whose side are you on?
A. You can't just dismiss it as the markets overreacting. What the markets are responding to is that India's economy is saddled with structural issues that are showing up in lower growth, persistently high inflation, and the high current account deficit. The tapering-related fears are affecting India in particular. Overall, related to emerging markets, the [currency] markets are overshooting a little bit at the moment. But that is the nature of the game when there is uncertainty on the table: when will the QE (Quantitative Easing) begin to taper, and what its implications are, and what the growth story is going to look like in emerging markets. In an environment like that, countries like India where there are more concerns about macro fundamentals will get affected more. Market behaviour is not irrational, though it may be overshooting a bit right now. At the end of the day it says you have certain risk preferences and when the uncertainly increases you want to pull back a little.

Q. What you are saying ties in well with what is happening in Bangladesh, whose currency has been appreciating against the dollar for a year, even after the tapering announcement.
A. There is differentiation taking place in the market. When generally there is a higher level of uncertainty, people err on the side of caution. So some markets may not have the same fundamentals as India. But overall, at least in the currency space, currencies like the Indian rupee and Indonesian rupiah are more at risk because of their current account deficit.

Q. You have said that the Reserve Bank of India should go ahead with conventional monetary policy measures, including repo rate hikes, even if they affect growth. That may not have pleased many of your followers.
A. Right now what the RBI should focus on is currency stabilisation measures and tighten the monetary conditions, as they have done. Also, on balance there is a need to contain domestic demand to make sure the current account deficit is on a downward trajectory. The monetary policy has a role to play in that context. You can focus on temporary measures, as is being done now, but it also potentially creates complications. The question is do you keep these measures in place or do you focus on balancing risks when it comes to growth. It becomes more difficult the longer you have to keep it in place. It is important for the RBI to be more clear in its communication that the currency stabilisation measures will be in place until the currency stabilises. And more will be done if needed. If you look at the existing measures, they are looking at the short end of the curve, working on the assumption that the pressure on the currency will taper off. They have to be in place until the pressure subsides and should be made more effective until there are stable conditions in the currency markets. And also signal that they will tighten the measures if necessary.

You have to keep in mind that the weakening of the currency is leading to inflation. Monetary tightening measures will help contain the import bill. The difficult part is that it will mean more inflation. At the end of the day it is about containing imbalances. One of the tools you have to do that is monetary policy in the conventional way.

Q. Economist Paul Krugman says he does not understand the panic over the falling rupee. According to his calculations the rupee's Real Effective Exchange Rate (REER) is 88 to the dollar, compared to 110 for Brazil's real. Do you think the panic is justified?
A. Whether from the policy side or the investor side we should be as worried as the markets are. It reflects the heightened level of uncertainty both from the global side and also specific to India: whether things will turn around, whether there will be a suitable policy response. We should not necessarily compare what the fundamental value of the currency should be in normal circumstances at a time of uncertainty and heightened risk aversion. Of course, when you have money at stake these things matter.

Q. And Krugman doesn't.
A. Yeah.

Q. Does the currency meltdown in emerging markets remind you of the East Asian crisis of 1997/98?
A. There are legitimate concerns and some countries are facing more challenges now than others. India finds itself in a challenging condition. But to say that emerging markets as a whole are in a situation of the East Asian crisis of '97/98 is a stretch. They had a heavily managed exchange rate, and had significant un-hedged short-term external liabilities. Part of the reason it was not hedged was that the currencies were managed. If you took out a loan, you would be comfortable that the currency would not be too volatile. Number two, corporate and balance sheets back in the Asian crisis were much weaker than they are now. Asian countries learned from the crisis and that strengthened the fundamentals of their economies. They are in a better shape now. Foreign exchange coverage is much better than it was then. They have more cushion. Monetary and fiscal policy institutions are today stronger than they were then. Not that there are no risks; there will be further pressure on emerging market currencies, but they are stronger today. Another point is that if you look at the global backdrop, the Fed (US Federal Reserve) is lining up for tapering, but even when the Fed begins to taper, it will have a loose monetary policy in place. It will reduce monthly purchase of securities, but is not about to raise policy rates. Closer home, the Bank of Japan is in the process of doubling its balance sheet. That will partly set off the Fed's tapering. There will be significant liquidity and easy monetary policy in advanced economies. That is a friendlier global backdrop than you had in the late 1990s. The market is merely going through a re-pricing of emerging versus advanced markets. But we are not on a trajectory to go into a full currency crisis.

*The last answer in an earlier version of this interview has been deleted because an off-the-record statement inadvertently was uploaded.