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There is nothing novel about using monetary policy to defend the exchange rate—it is a classic textbook response, which has been adopted by many emerging market central banks during periods of currency crisis. During the late 1990s, the Reserve Bank of India (RBI) tightened liquidity and hiked interest rates to defend the currency many times.

How do higher interest rates help? According to standard theories, it raises the cost of shorting the Indian currency, reduces the adverse impact on corporates with large external liabilities, makes the rupee more attractive to hold, and is also an important signal that the central bank is committed to exchange-rate stability. That’s the theory, but will it work in practice? In our view, given the current macroeconomic picture, the costs outweigh the benefits.

Sharp rupee depreciation in May-June was not driven by an India-specific speculative attack. Most emerging market (EM) currencies depreciated and those from countries with higher current account deficits (such as India) weakened more. Even the stability that the rupee has enjoyed over the last three weeks is not unique; all EM currencies have stabilized recently. Hence, whether the recent RBI measures have played an important role remains to be seen.

Fundamentally, the currency was poised to depreciate. Apart from weak exports and high oil prices, there are many domestic reasons for the high current account deficit: high inflation (promoting gold demand); rising debt capital inflows (outflow of investment income); greater commodity-intensity of imports (such as oil, coal, fertilizer, edible oils); and domestic supply-side constraints, which have led to imports substituting for domestic production. Unless the basic issues are sorted out, putting quantitative restrictions on imports or garnering more dollars from abroad will only provide a temporary reprieve.

In fact, trying to defend a particular level on a currency can backfire. As the RBI loses its monetary policy independence trying to defend the currency, credit risk is on the rise. Economic growth risks grinding to a halt as capital becomes expensive and scarce. Real GDP (gross domestic product) growth in FY14 should not be very different from last year’s decade-low 5%, despite better agriculture performance.

Given rising leverage on domestic corporate balance sheets (particularly in the construction, infrastructure development, power generation, telecom and metals sectors), tight liquidity will elongate working capital cycles and can lead to increased corporate defaults.

The banking system is also at risk as it is stuck between a rock and a hard place. Funding costs are rising, likely compressing bank margins, but if banks raise lending rates, the risk of default rises. Already, non-performing loans and restructured assets account for around 10% of total loans, from less than 4% in FY08. Tighter liquidity, higher interest rates, shrinking margins and the rising risk of corporate default increases banking system stress and puts the entire financial system at risk.

As corporate and banking system balance sheets come under pressure, not to mention the government’s fiscal finances, who could blame investors for shying away. Growth-sensitive equity inflows may well reverse, putting further depreciation pressure on the rupee, necessitating even higher interest rates to defend the currency. And so the circle is clear.

In our view, rather than artificially trying to draw a line in the sand on the currency at the cost of creating a domestic credit crisis, policymakers should allow a gradual currency depreciation and the government needs to significantly tighten its fiscal belt and announce real reforms rather than band-aid solutions.

There is a general perception (reinforced by the RBI) that the recent liquidity-tightening measures are very temporary, but there is no guarantee that depreciation pressures will end within that timeframe. Concerns over the US Fed tapering its debt-purchase programme and slowing emerging market growth means investors remain cautious on EMs, hence external financing difficulties may continue for much longer. But the longer the depreciation pressure continues, the longer the measures will need to remain in place and the greater the stress on domestic balance sheets, leading to higher credit risk.

As such, the interest rate defence of the exchange rate may or may not work in the short term, but unless fundamental issues are resolved, artificially suppressing the currency will only lead to greater collateral damage, which in the end will be even more detrimental to the currency. A failed defence is worse than no defence at all.

Sonal Varma is executive director and India Economist, Nomura Financial Advisory & Securities India Pvt. Ltd.

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