By Bloomberg

By Bloomberg

Rupee plunge tantamount to 100 bps of rate cuts

Rupee plunge tantamount to 100 bps of rate cuts

As it turns out, Monday’s Reserve Bank of India (RBI) meeting is sandwiched amid potentially game-changing events around the world. Will the political machinations in India over the last 72 hours result in politics becoming fundamentally more supportive of policy? Will the Greek elections be decisive and game-changing? Is the US Federal Open Market Committee all set to put its foot on the gas again?

By Bloomberg

This raises two important questions. First, are rate cuts the magic bullet that will jump-start the investment cycle? Suffice to say, real interest rates were negative through nearly all of 2011 and, even today, are significantly lower than their levels in the mid-2000s when investment and industry were booming. So they cannot be the primary problem.

But there is a larger, more fundamental, question. Are interest rates and liquidity the only determinants of monetary conditions? The answer is no. These variables can influence domestic demand (consumption and investment). But the more open an economy is, the more the exchange rate matters in influencing external demand (exports). So, while an interest rate may be the key price that affects activity in the non-tradable sector, the exchange rate is a key price that affects activity in the tradable sector (not just exports but also import competing activities). Any measure of monetary conditions, therefore, needs to factor in both these prices as well as domestic liquidity conditions.

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Why is this relevant for India? Because monetary conditions are being shaped by various cross-currents. On the one hand, inter-bank liquidity continues to remain tight—leading to calls for cash reserve ratio cuts. On the other, the policy rates, which were increased by 225 bps in 2011, have been cut by 50 bps already in 2012. Most of all, the exchange rate has depreciated by almost 20% since last August.

So, have the monetary conditions tightened or loosened from a year ago?

Thankfully, we don’t need to reinvent the wheel to answer. Various central banks around the world construct a monetary conditions index—a weighted average of market interest rates and the nominal effective exchange rate—to assess the tightness of monetary conditions. The weights are determined by estimating the impact of real interest rates and real exchange rates on activity. The more open the economy, one should find a higher relative weight on the exchange rate.

In a 2006 working paper, RBI found a surprisingly strong weight on the exchange rate: the impact of a 1% increase (decrease) of the interest rate on activity is equivalent to that of a 1.4% appreciation (depreciation) of the exchange rate. This seems like a large weight on the exchange rate, particularly in 2006, when India was less open. Conversely, the International Monetary Fund estimates a 1% cut in interest rates is equivalent to a 10% depreciation of the nominal effective exchange rate. This may seem excessively conservative, given India’s ever-growing tradabales sector (gross exports are almost 30% of gross domestic product, or GDP) but ties in with our notion that the price elasticity of India’s exports are low. We obtain a similar result—that the impact of interest rates on activity is 10 times that of the exchange rate. In other words, we are being very conservative of the role of exchange rate on economic activity—which seems appropriate in the current fragile global environment.

So, based on this, how have the monetary conditions evolved? Unsurprisingly, they were very loose in early 2010 when inflation surged. The rate hikes of 2011 tightened conditions but were partially offset by the currency weakening since August. However, when the currency bounced back in early 2012, monetary conditions tightened again and peaked in March 2012.

Since then, however, there has a been a dramatic loosening of monetary conditions. The nominal effective exchange rate has depreciated by 10% since March, compounded by the 50 bps policy rate cut in April. As such, the Monetary Conditions Index (MCI) is at its lowest level since October 2010—20 months ago, when RBI was still in the early stages of its rate normalization process.

Furthermore, for those arguing for substantial rate cuts, remember that the monetary conditions now are marginally lower than their average in the 2002-07 period (India’s macroeconomic sweet spot), despite current inflation being well above 7%, against less than 5% in those years.

Finally, despite being conservative on the exchange rate, MCI suggests that the 10% nominal effective exchange rate depreciation since March is equivalent to 100 bps of rate cuts. Put another way, the monetary conditions would have been at similar levels today if the exchange rate had remained at its March 2012 levels, but rates had been cut by another 100 bps since March.

None of this suggests that RBI will not cut interest rates today. It very well might. But for those arguing for substantial monetary easing over the coming months, they may have already got their wish.

Graphic by Sandeep Bhatnagar/Mint

Sajjid Chinoy is India economist, JPMorgan.

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