A horse-drawn cart is silhouetted as it moves along a road shrouded in smog in New Delhi, India. (Photographer: Anindito Mukherjee/Bloomberg)

Rupee, Rates, Deficits, And Blinkered Policy Choices


The Inflation Blinker

In the midst of this week’s currency volatility, India had two major data releases.

After Monday’s encouragingly low July Consumer Price Index print of 4.17 percent, analysts called for an extended monetary pause from the Monetary Policy Committee. Some also suggested that Reserve Bank of India should arrest further rupee depreciation, to control CPI over the medium term.

To me, this reflects the CPI blinkers over our policy thinking.

There are considerations beyond CPI, as Tuesday’s July trade deficit print of $18 billion painfully reminded us.

Our overall financial stability context—across the external sector, fiscal balance and the health of our financial ecosystem—is still vulnerable. 

Given this, policymakers have to consider the larger picture and keep alive the option for further monetary tightening and controlled currency depreciation.

Monetary Policy And External Vulnerabilities

While the current currency volatility was triggered by external events, our core issue remains the unhealthy external balance that has developed over time.

In some ways, our CPI-blinkered monetary framework has actually contributed to the buildup of this vulnerability.

  • To begin with, our current account deficit worsened from $15 billion in 2016-17 to $49 billion in 2017-18. Higher oil prices were only partly to blame. Exports struggled, while we guzzled smartphones and gold.
  • Alongside, our net foreign direct investment dropped from $36 billion in FY17 to $30 billion in FY18.
  • Across CAD and FDI, our total permanent flows flipped from an inflow of $21 billion in FY17 to an outflow of $19 billion in FY18.

As a natural adjustment, this should have resulted in a weaker rupee. Instead, the rupee appreciated in real terms. In fact, rather than have to supply the $19 billion core deficit, the RBI net purchased $44 billion from the market in FY18, adding to its currency reserves.

So where did the extra $63 billion in FY18 come from? This is where monetary policy played a role.

High real rates at a time of benign macros and surplus global liquidity attracted foreign portfolio investment in debt, net exporter forward-selling, unhedged external commercial borrowings, and other speculative carry positions.

While focusing on inflation, our policy framework missed this external vulnerability buildup.

RBI Governor Urjit Patel’s comments after the monetary policy meeting on June 6, 2018.
RBI Governor Urjit Patel’s comments after the monetary policy meeting on June 6, 2018.

Fast-Forward To Today: The RBI And MPC

As the context turns adverse, these accumulated currency positions are now nervous. In FY19 so far, about $15-20 billion of such flows may have reversed, causing the current currency volatility.

The resulting rupee depreciation should actually help control our import demand, and eventually, improve exports – but such adjustments take time.

In the meantime, RBI has to intervene judiciously, allowing controlled rupee depreciation so that permanent flows may better balance while staving off any panic.

The RBI and MPC must look beyond the immediate CPI, and consider the overall financial stability context and market expectations in their deliberations. CPI might stay stable and even decline further over the next few months.

However, a dovish policy response could portray us as behind the curve, and create additional volatility in our nervous currency markets. 

The Government

First, as the Turkey experience tells us, we must reinforce the credibility of our institutions.

Delhi should not comment on currency or interest rate movements or, otherwise, be seen to interfere in the working of the RBI. 
RBI Governor Urjit Patel and Finance Minister Arun Jaitley at a seminar on the Insolvency and Bankruptcy Code in Mumbai on August 19, 2017. (Photograph: PTI)
RBI Governor Urjit Patel and Finance Minister Arun Jaitley at a seminar on the Insolvency and Bankruptcy Code in Mumbai on August 19, 2017. (Photograph: PTI)

Also read: RBI Intervention May Not Help Stabilise Rupee, Says Economic Affairs Secretary

Second, the core issues on trade need addressing. Industry experts have provided many suggestions for improving exports and Indian manufacturing – they need to be acted upon.

Third, given the overall context, it must control the fiscal deficit. As it is, Goods and Services Tax collection trends, minimum support price increases, and higher oil subsidies will cause fiscal slippage this election year. In addition, the quality of the fiscal spending has been deteriorating, with increasing revenue deficit and lower capital expenditure.

Fourth, our banking sector issues still await resolution. We have seen multiple plans to further resolve non-performing assets, further recapitalise banks, and reform banking. Now is a good time to start implementing them.

Finally, we will, of course, pray that oil comes back to below $50, that trade wars subside, and that our markets stabilise. But these prayers should not come in the way of us addressing the core issues around our financial stability – the external and internal imbalances, and the health of our financial sector.

Ananth Narayan is Associate Professor-Finance at SPJIMR. He was previously Standard Chartered Bank’s Regional Head of Financial Markets for ASEAN and South Asia.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.