It’s not just G7 central bankers that are in crisis-fighting mode. Take India, an economy that – against market expectations – has been hit by the global crisis and is struggling to shore up credit conditions with conventional monetary policy tools. Sound familiar?
In the fourth quarter of last year, the impact of the historic decline of the rupee was both material – on inflation, trade and capital-market trends – and symbolic. In short, it highlighted the country’s correlation with global markets, laying bare the India decoupling myth, and provided yet another kick in the teeth for the beleaguered Congress-led coalition.
For economists, the rupee’s precipitous decline – a 21% fall against the dollar between August and December – shone a light on the country’s structural vulnerabilities, including its current account deficit and high energy-importing needs, as well as the vexed art of monetary policy-making.
On the latter, in recent months, the Reserve Bank of India (RBI) has opted to use alternative policy tools to shore up growth/the exchange rate – principally reducing the cash reserve ratio to boost banking liquidity – rather than the repo rate itself, its benchmark rate, citing stubborn inflation. (Though, naturally the RBI rarely admits FX concerns will influence policy rates.)
In an effort to throw everything but the kitchen sink at the forex markets – i.e. without hiking the benchmark rate – the authorities, among other things, have actively intervened in the forex market, both spot and forward, and raised external commercial borrowing and foreign debt-ownership limits. To some extent, these efforts – combined with a resurgence of foreign capital, of course – are paying off; the Indian currency has appreciated by around 5% year-to-date.
However, Nomura analysts reckon structural and cyclical pressures for banking sector illiquidity and FX volatility remain intact, and that the RBI may soon have to become more aggressive by launching open-market operations and hiking its benchmark rate:
| India is relatively vulnerable from a scenario of capital flight given the large current account deficit and dependence on equity flows. This vulnerability is still intact and will re-emerge if a phase of deleveraging/repatriation re-emerges from the eurozone.
There are other concerns for INR ahead including the risk that the volatility of INR may increase on reduced liquidity following RBI‟s recent action against FX activity. In addition, other negative flow concerns remain intact, including the consistent USD demand from importers, the risk that the option related USD demand (hedge related) will re-emerge (if spot USD/INR trades back towards recent highs). There is also sizeable maturing convertible bonds in 1Q12 of around US$6bn (not even including maturing ECB). Given FX reserves have fallen by USD26.4bn (9.2% of FX reserves) from July 2011 to the first week of 2012, there are also questions over the sustainability of RBI FX intervention. Note that India‟s FX reserves-to-GDP is around 17% of GDP and daily turnover in the FX market is around USD6bn. Although the favourable policy responses from RBI have helped to stabilize INR, more measures on FDI liberalization as well as RBI providing USDs to oil corporates are still required to help lower INR vulnerability and especially given the risk of renewed external shocks ahead. |
The monetary environment is a sharp about-turn compared with 2007, when the central bank was overwhelmed by a surge in liquidity, leading to calls that the RBI should allow for a stronger rupee as an inflation-fighting tool. The liquidity flood was, in part at least, down to the central bank’s open market operations to stem rupee appreciation, triggered by capital inflows. The move highlighted the RBI’s competing priorities of an independent monetary policy, an open capital account and a managed exchange rate, known as the ‘impossible trinity’ dilemma.
Now, however, the central bank is faced with a new impossible trinity, a point well made by Sourav Majumdar of India’s First Post:
| [The] RBI will continue to seek what can clearly be called an ‘impossible trinity’ of three ‘expected outcomes’ – easing liquidity conditions, mitigating downside risks to growth and continuing to anchor medium-term inflation expectations on the basis of a credible commitment to low and stable inflation. |
And yet, as RBI Governor Duvvuri Subbarao has loudly decried for several years now, most recently in his quarterly monetary policy statement last month, fiscal expansion is inflationary and further complicating its monetary stance. Mr. Mukherjee, are you listening?
Further reading:
Indian central bank: no rate cuts without fiscal consolidation