The risk of a rupee crash looms large
The costs from a rupee crash will exceed the benefits accruing from stable to lower interest rates
On 27 April, the Reserve Bank of India (RBI) announced a relaxation in norms (all-in costs and eligible borrowers) for external commercial borrowings (ECBs). On 1 May, RBI announced some relaxation in norms for investment by foreign portfolio investors (FPIs) in Indian debt. FPIs can now buy bonds with residual maturity of less than one year across government and corporate issuers, subject to a ceiling of 20% investment by that FPI across all categories of bonds. On 4 May, RBI announced that it would conduct open market operations (OMOs) to the tune of Rs10,000 crore. Through OMOs, the central bank buys government bonds and credits the accounts of the banks from which it buys. It will help increase liquidity.
In a research note published on 8 May, economists at JP Morgan India estimate that the cash-to-gross domestic product (GDP) ratio is rising, presumably due to improvement in the rural economy. This demand for cash is unlikely to be met by the RBI buying foreign exchange and letting domestic money circulation rise because India does not expect strong foreign currency inflows this year. Even though net portfolio investment flows have been much stronger at $19.84 billion, the high and rising trade deficit and the persistence of oil price over $70 per barrel will see to that. On a net basis, foreign direct investment (FDI) as per RBI balance of payments (BoP) statistics, for the first nine months of 2017-18, amounted to $23.73 billion—lower than the $30.57 billion for the same period in 2016-17. Finally, in September 2017, RBI reported that India’s external debt with residual maturity of less than one year amounted to about $120 billion, net of non-resident Indian deposits. Hence, the RBI has to engage in OMOs to the tune of Rs1.1 trillion in the current financial year, according to JP Morgan.
Generally, the money demand function is hard to estimate. Hence, money demand is only indirectly perceived through money supply. Base money expansion happens based on assumptions of nominal GDP growth, velocity of circulation of money, mainly. If the central bank perceives the need to do OMO, then, it is a sign that it is accommodating demand for cash, rather than letting interest rates rise. The currency in circulation and demand deposits with banks have grown at a compounded annual growth rate (CAGR) of over 12.2% in the last four years (end-March 2014 to end-March 2018). That is somewhat higher than the 10.5% CAGR in nominal GDP during the same period.
Therefore, market participants have correctly concluded that RBI is interested in holding down the government borrowing cost. That is only going to further aggravate the issue of inadequate demand (inadequate demand at five government bond auctions in as many weeks), with the bonds eventually ending up in the RBI balance sheet. If bond yields do not compensate for inflation, then banks won’t be interested in holding government debt securities more than necessary under statutory requirements.
This may help hold down the government borrowing cost but only for a while. Between 2012 and 2013, the 10-year Indian government bond yield did come down from around 9% to 7.5%. But, if one expanded the window to the period between 2009 and 2014, the 10-year bond yield went from 7% in March 2009 to 8.8% in March 2014. In this period, the net RBI credit to the government (and this, on paper, includes state governments too) ballooned from Rs61,580 crore to Rs6.98 trillion—that is more than 11 times. Inflation raged for five years and the rupee did a cliff-dive in 2013. RBI had to content itself with writing a long chapter on the fiscal dominance of monetary policy in its “Report On Currency And Finance” for the period 2009-12.
To the credit of this government, it has been fiscally far more prudent than its predecessor. Internal market borrowing (including amounts borrowed from national savings schemes) has grown at a CAGR of 2% in the last four years compared to 18% CAGR in the 10 years (it is 29% CAGR in nine years from March 2005) of the United Progressive Alliance government. It will be a tragedy to dissipate all this hard work of the last four years in the final year before the national election. Let the government borrowing programme and the demand for money reflect in interest rates so that the latter has a restraining effect on aggregate demand.
The price of oil is firm and the Persian Gulf faces uncertain times. Inflation risks are tilted to the upside from rising farm prices and uncertain monsoon rainfall distribution. The Federal Reserve is raising interest rates. Several emerging economies are in trouble and dollar demand for repayment is set to rise as US dollar securities issuance by non-bank borrowers in emerging economies went up by 22% in 2017. India too is in need of dollars for debt repayment and purchase of crude. The costs from a rupee crash will exceed the benefits accruing from stable to lower interest rates. National pride will be a hard-sell in the 2019 election with an emaciated rupee.
On its part, RBI must go back to the drawing board and examine what exactly it is targeting and why. There is the official inflation target. But OMOs smack of interest rate intervention. Autonomous central banks exist only to hold back politicians from priming the pump in an election year, with medium-term adverse consequences. Relaxing ECB and FPI norms hints at desperation on the exchange rate. In trying to be all things to all people, RBI is risking its own credibility and encouraging discussions on its competence too.
V. Anantha Nageswaran is an independent consultant based in Singapore. He blogs regularly at Thegoldstandardsite.wordpress.com. Read Anantha’s Mint columns at www.livemint.com/baretalk
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