Urjit Patel, governor of the Reserve Bank of India (Photographer: Dhiraj Singh/Bloomberg)

Should The MPC Weigh A Rate Hike To Defend The Rupee?

India’s monetary policy committee has been moving closer to a rate hike. At the last meeting in April, one of its six members voted for a rate hike; a second indicated that he will vote for a tighter monetary policy stance in June; and at least two others, including RBI Governor Urjit Patel, called for vigilance on inflation.

Since then, inflation, particularly core inflation, has remained elevated. To that, a new level of uncertainty has been added via a falling currency. Together, these factors could tilt the scales in favour of higher rates, said Jahangir Aziz, chief emerging market economist at JPMorgan. The June 6 MPC decision will hinge on how the committee views the weakness in the rupee, Aziz told BloombergQuint in an interview.

Aziz believes the MPC needs to view the rupee depreciation through the lens of financial stability, while also taking into account the inflation impact of a weaker currency.

My guess is this factor is going to play a much bigger role in the June meeting than the inflation dynamics. Inflation is moving up. Core inflation has not just been sticky but also picked up. If exchange rates keep on depreciating, whether through transportation prices or through imported prices, it will have a second-round effect. So, it is not just that it is being done for financial stability but also for future inflation.
Jahangir Aziz, Chief Emerging Market Economist, JPMorgan

The Indian rupee has weakened by 6.44 percent so far in 2018, shows Bloomberg data. It has under-performed peers like the Indonesian rupiah, which has weakened 5.13 percent, and the the Philippine peso, which has slipped 4.15 percent.

However, Asian emerging economies are far better placed than countries like Turkey and Argentina, which have had to resort to sharp rate hikes to protect their currency. Indonesia, too, hiked rates for the first time in four years this month.

Aziz believes that other emerging economies will have to consider similar measures. “...just like Indonesia, which didn’t face any inflationary pressures but did hike (rates), you will see emerging economies across the world hiking for financial stability reasons and the RBI will be part of it.”

Not everyone agrees that the rate defence is effective for an economy like India.

“Experience shows that only one of the three monetary tightening actions -- Governor [Bimal] Jalan’s January 1998 measures -- had even partial success in fending off a currency attack,” Indranil Sen Gupta, chief India economist at Bank of America-Merrill Lynch, wrote in a note dated May 17.

The most recent attempt to defend the rupee using interest rates was in July 2013, when the RBI hiked the marginal standing facility rate by 200 basis points. At the time, the rupee was hurtling towards a record low and the rate was hiked as an attempt to restore financial stability. The move did little to help and the currency hit a record closing low of 68.82 against the dollar on August 28, 2013.

According to Sen Gupta, rate hikes hurt more than they help in India’s case. This is because of the dominance of equities in foreign portfolio flows.

Experience teaches us that rate hikes have hurt the rupee. This is because portfolio investment is dominated by equities (at $470 billion), which are attracted by growth rather than bonds ($80 billion), in contrast to most other emerging markets.
Indranil Sen Gupta, Chief India Economist, Bank of America-Merrill Lynch

The one time that monetary action helped stabilise the foreign exchange markets was during the Asian financial crisis, wrote Sen Gupta while adding that even then the country had to raise Resurgent India Bonds to shore up its currency defence.

In 2013 too, when the hike in short-term rates failed to protect the currency, India had to raise overseas deposits via a subscribed foreign currency non-resident deposit scheme. Sen Gupta believes a similar strategy may be more effective at the current juncture should pressure on the rupee continue.

“The RBI will likely raise $30-35 billion by way of NRI bonds to shore up forex reserves with oil set to stay above $70/barrel in 2018-19,” wrote Sen Gupta.

For JPMorgan’s view on emerging markets and the Indian economy, listen here:

Here are the edited excerpts of the interaction:

What is your view on the broader emerging market issue?

If you look at the way emerging markets have been over the last 20 years; the key drivers of emerging market capital flows are two variables- one is the growth gap between emerging market and developed market. the larger the growth gap, the more capital flow is in, simply because emerging market is a risky place to invest, so you need something to compensate you for the risk. Growth compensates you for the risk. The greater the compensation the more is the capital flow, that’s the key driver. And what we saw from 2010 to 2015 is that this emerging and developed market growth differential, kept on falling almost relentlessly and with that capital flows and with that across every asset class emerging markets, under-performed developed market assets.

We have seen this turn-around take place, from around first quarter of 2016 till the first quarter of 2018, emerging market’s growth differentials widened in favour of emerging markets, that drew the capital. And if you look at any consensus view of the 2018 and 2019, you will still find that emerging and developed market growth differentials are going to widen in favour of emerging markets and therefore if the last 20 years has been any indicator, you should continue to see capital flows in.

The other variable which has an enormous effect on the emerging market capital flows is not interest rates. So, if you look at interest rate differential, there is no real correlation between that and capital flows, instead its dollar strength. So even if you take any kind of a measure of dollar strength. We usually like to use the standard dollar/euro spot trade, that has a significant negative effect on capital flows.

What we saw was that in 2016-2017, up till the first quarter of 2018, in the absence of dollar strength, emerging market growth differential that was widening in favour of emerging markets, driving the capital into emerging markets. And when we saw in April the emergence of dollar strength, and that’s the one that has pushed back the flows into capital markets, and again you know, as you were pointing out, it has been differentiated across the current accounts plus low yielding economies, which have been less hurt by this dollar strength and of course the high-yielders, current account deficit economies which have been hurt the most in the emergence of dollar strength, as it should be. There’s a reason why high-yielders are high yielders. They hide a lot of macro-economic imbalance by the high yield. And consequently, when times are tough, the imbalances surface, and they get it.

You had earlier said that you don’t expect the dollar strength to persist, or you know to at-least extend in a big way. But what about volatility, how much of an impact does volatility have on capital flows?

Volatility does have capital flows, in the sense that, you know, if you look at the last 20 years, early 2000 and 2010 let’s say- time when volatility was very high or ‘normal’, you had the largest capital flows into emerging markets. In the period from 2010 to 2015, when the volatility was completely swamped to town, that’s the time when capital flows fell every quarter into emerging markets. So, I know there are a lot of people who believe rising volatility and rising rates makes a difference and am sure that some point in time that might be true but the last 20 years of evidence suggests that those are not the key drivers of capital flows, instead it’s again, emerging and developed market differential and dollar strength. And that’s what we are facing right now.

How much of what India is facing right now- first on the capital flow side is global and how much is Indian. Because I think we were looking at the debt numbers, we were the worst in Asia in terms of outflows from debt?

Sure, again you know this an emerging market and it’s an emerging market with a high yield or emerging market countries, there is a reason why we have to pay high yields. Because we have chronic macro-economic imbalances. Indonesia and India in the Asia region fall into that category. And what we have so far is that the rise in dollar strength accompanied by the rise in U.S. rates has been of the reasons as to why money has flown out. But I don’t that’s the primary reason that money has flown out, I think the money has or the fixed income people have become more skeptical about India prospects has to do with the fact that India is an economy where fiscal deficit was broadly around 7 percent for the last 3 or 4 years. Current account deficit, maybe for the wrong reasons was broadly around 1 percent. Now you have fiscal deficit moving from 7 percent towards 8 percent we don’t know where it will go but 7 towards 8, and the current account moving from 1 to 3.

If you have an economy with rising fiscal deficit and widening current account deficit- two things happen- interest rates go up and the currency depreciates. That’s not the place where fixed income and investors want to be.

There are India specific issues as well.

Which is current account deficit going and fiscal deficit going up.

What does this mean for market structural issues? The bond strike and rates…

The management of government borrowing in this particular time, there was a significant change from what used to be the case over the last three years. Not just in terms of the quantum which is being issued in the first half of this year but also the tenure. So, obviously the market has to get used to it. More important is that we are seeing in the time of financials when statutory liquidity rates were very high and banks, public sector banks particularly, which were holding significant amount of bonds on the portfolio, could blindly hold it till maturity and never had to pay the price of marking their books to market.

Suddenly with the decline in HDM, there is significant pressure on managing risk. So, one side of the market where the private sector is buying and selling, the public sector has to be on other side of it. Public sector banks are the one’s who are in the transition period getting away from the old model where they could hold 10 years to maturity to now actually having to worry about mark to market losses. So, there has been these changes which has affected them.

On a broader macro basis, there are not so much structural changes. Suppose at current environment current account was at 1 percent and fiscal deficit was coming down, even with the structural changes, I don’t see that kind of pressure on bond prices or the exchanges. That’s my point.

Right now, we are facing two tough decisions. One is whether we hike rates now or we should have hiked rates earlier. What are your thoughts?

I think there is a lot of emphasis on inflation process in India and we tend to think that interest rate movements is almost entirely tied to what future inflation will be and inflation dynamics. I am not saying that should not be the case. That should be the case.

At this point of time, the financial stability, you can use that euphemism for anything, whether it is banking sector and profitability on one hand or the exchanger on the other hand, comes into play. So, given the fact that you have seen 1-1.5 month’s of dollar strength and the rupee has depreciated and we haven’t seen the end of the dollar strength; my guess is this factor is going to play much bigger role in June meeting than the inflation dynamics.

Inflation is moving up. Core inflation has not just been sticky but also picked up. If exchange rates keep on depreciating, whether through transportation prices or through imported prices, it will have a second-round effect. So, it is not just that it is being done for financial stability but also for future inflation. The June 6 MPC review call will hinge on how RBI sees dollar strength continue and rupee rather than what his views on inflation.

So, you won’t be surprised if there is rate hike?

If we continue to see dollar strength and the rupee heads beyond Rs 69 per dollar and continued rupee weakness then my guess is that, just like Indonesia did where they didn’t face any inflationary measures but did hike, you will see emerging market countries across the world hiking for financial stability reasons and RBI will be part of it. The difference between that kind of hiking and hiking for inflation purpose is that you can getaway with 1-2 hikes if you are just doing financial stability. If you are doing it for inflation, you will need to enter into a hiking cycle.

Do you think the rate defense for rupee will going to be effective? It hasn’t been in the past, although those were entirely different conditions.

Right. But if you do not use rate defense now, you have to depend on other instruments much more which is reserves. In general, life is in between. You want to use all instruments that are at your disposal and you can’t rely on a single instrument.

If you think that we can get away by not doing anything on rates but doing anything on the foreign exchange, then the amount of foreign exchange losses could be significant.I have no idea how much the foreign exchange losses will be. So, you have to balance one of them. So, you do a rate hike of 25 bps or even 50 bps if dollar strength does not stabilise. That means you have to do less on the foreign exchange front if you are trying to slow down the pace or path of depreciation. You cannot go against the path of depreciation. This is happening because of global factors, current account widening. You at the best can smoothen out the path which is what the RBI is trying to do.

On the fiscal side, the decision is on oil, do you worsen your fiscal position by cutting excise which you have piled on? There is a consumer versus fiscal debate.

This is not with hindsight. Back in 2015, when oil prices started to fall and in 2016 we did write extensively about it. So, I am not saying that with hindsight everybody has to due into vision. Perhaps, we shouldn’t have done what we have done which is not allow entire decline in oil prices from Rs 125 to Rs 25 to be taken up by high excise taxes and then use that for public expenditure and capital. That was the basic formula at that point of time.

First of all, decline of oil prices has nothing to do with any effort done by India. So, this was pure windfall gain. And we seriously took advantage of that to make sure that we will not force to fiscally consolidate during that period of time. I think it is pay back time.

They need to go and lead the excise taxes, ease all the excise taxes and start cutting elsewhere to meet the deficit. It was a windfall gain and now it is time to give back. You cannot say that I will take the windfall gain and not give it back. When the government decide to use the windfall gain for additional revenue they should have known that there would be a time in future when they will have to give it back. This is the time.

And it has come at the time when anyway inflation is picking up and so there will be growth impact too. Consumer spending has held us up.

Which is typically why people don’t use windfall gain for these purposes. You try to save windfall gains. You do that in your own personal account. Even if you do spend windfall gains, you do find it typically when you need. To use that space is usually during a bad time. It is never really a good time. When oil prices would go up you knew that we will be under pressure but that was exactly the time when we need to reverse the excise taxes. My economist tells me that almost 50 percent of oil priced today is some form of taxes, whether it is from state government or by center. That is very large amount of revenue stream. That means the state know that the central government should have imagine that this would go on forever.

Not all is bad, and we have GDP number coming up. Growth has starting to look steady and investment has also started to pick up moderately.

We went through two large shocks, one was demonetisation disruption in supply side and then came the GST disruptions. Both the shocks have been waning out and we are seeing a lift coming out from there.

It is glad to see that people are talking about investing again. Credit growth is picking up. Consumption is not doing badly. All of this should have happened two years ago when the global economy was moving up in synchronised recovery. We could not take advantage of it because of demonetisation and GST. But, better late than never.