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Business News/ Opinion / Adopting a barbell strategy
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Adopting a barbell strategy

Indian policymakers have to communicatewell to prevent short-term panic from turning into long-term rout

Illustration: Jayachandran/MintPremium
Illustration: Jayachandran/Mint

On 6 September 2011, the Swiss National Bank (SNB) issued a clear, concise and firm communication to put an end to the sharp appreciation of the Swiss franc. SNB in its statement said that it was aiming for a substantial and sustained weakening of the currency and would no longer tolerate a euro-franc exchange rate below 1.20.

The communication elicited an almost instantaneous response from financial markets with the franc trading within the desired range. While the Reserve Bank of India (RBI) today is facing quite the opposite challenge, with a depreciating rupee, the signalling and action could have been just as focused and single minded.

As stock market participants, we have learnt from Benjamin Graham that “in the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine". This has been the popular perception about markets, even for those who criticize the shortcomings of the efficient markets hypothesis. The long-held belief is that while there may be short-term deviations, financial markets eventually tend towards equilibrium, thus reflecting underlying fundamentals. However, what is often underestimated is that in the real world such deviations can become self-reinforcing, and may actually alter the equilibrium driven by fundamentals. In other words, like the proverbial tail wagging the dog, the short-term affects the long term.

This circular relationship between cause and effect is known as reflexivity. Reflexivity plays an important role in markets, which often focuses on the effect rather than the cause. If you scroll down the news ticker of a stock that has had a particularly bad day, you will notice that within minutes the news that caused the stock price weakness is quickly forgotten, and the price decline itself becomes the new news headline. As George Soros says, the new paradigm is that instead of being always right, financial markets may always be wrong. Markets have the ability, however, to both correct themselves but also occasionally to make their mistakes come true by a reflexive process of self validation. He suggests that financial markets may not predict economic downturns, but may actually cause them. For example, rising sovereign bond yields may transform a seemingly contained liquidity problem into an outright solvency crisis, as has been seen in the euro zone in the recent past. Headlines such as “rupee plunges to new lows" create a negative feedback loop, where the effect (rupee depreciation) ends up becoming the cause for further depreciation.

India is not the only emerging market to have suffered a rout in the currency market in recent times. Four other markets have suffered a similar fate: Brazil, Indonesia, Turkey and South Africa. The common thread that made them vulnerable is current account deficit (CAD) in excess of 4% of gross domestic product (GDP) in each case. Central bankers in these countries attempted policy responses they assumed were most appropriate, but their currencies met a similar fate. While Brazil announced a $60 billion intervention programme, South Africa preferred not to intervene. Similarly, while RBI was criticized for raising short-term rates, Bank Indonesia was accused of not raising rates enough. So the conclusion that some may draw is that, apart from fixing the current account problem there is nothing that countries can do to fight the global fear of tighter liquidity.

The recipe for a reflexivity spiral, as we have seen, is confusing signals in the short term and continued inaction on long-term structural reforms. Knee-jerk steps ostensibly meant for crisis management of CAD, such as increasing tariffs, curbs on imports and outward remittances often feed into the negative reflexivity loop. Studies have shown that in most episodes of currency crises, CAD peaks before the event. In India, too, it appears that CAD this year may be well below last year’s level of $90 billion or almost 5% of GDP.

The risk is that these negative reflexive loops can alter the fundamental fair value of the rupee, based on real effective exchange rate models. A weaker rupee could bring back inflation, widen the deficits, slow growth further, raise bond yields and make foreign investors want to exit. Each of these events could again cause further currency deprecation. Hence, it is important to address the psychology as much as it is to fix the fundamentals. Failure to influence short-term behaviour, as is observed in a bank run, could alter the fundamentals. History has shown that the word of a central banker wields immense clout over market participants, as was amply demonstrated by Mario Draghi of the European Central Bank (ECB) in July 2012, when he said “…ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough." and unlike the earlier SNB example, this assertion did not come from a position of strength, but with the euro zone having its back against the wall.

While we recognize the complexity of the current situation and are loathe to get onto the policy prescription bandwagon, we feel that, in the midst of a carnage, policymakers may consider adopting a barbell strategy. That is, at one end, address the market psychology for the short term through strong-worded communication, and at the other end, accelerate structural reforms that will make the economy more robust for the long term.

Amay Hattangadi and Swanand Kelkar are portfolio managers with Morgan Stanley Investment Management. These are their personal views.

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Published: 04 Sep 2013, 05:36 PM IST
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