As we near the halfway mark for 2018, it has been a challenging phase for emerging markets. Factors that led many of the region’s currencies to strengthen last year have weakened, as cyclical recovery faces risks from US-China trade tensions and policy normalisation in the US continues at a steady clip, tightening funding conditions. Policymakers have been keen to stay ahead of the curve to ensure carry trades return, by mirroring or outpacing the extent of policy tightening by the US and retain favourable rate differentials.
In Asia, policymakers have erred on the side of caution. Investors have become sensitive to economies that face overheating risks, characterised by twin deficits and high inflation, that could potentially unsettle macroeconomic stability. The Philippine central bank defended the peso from strong depreciation pressures by raising the benchmark rate by 25 basis points (bps) in April, with the consensus pricing in another 25bps hike this year. The currency is the second-worst performer on a year-to-date basis, as a widening trade deficit resulted in the economy’s first current account deficit in five years, coupled with inflation that is above official targets. Indonesia’s currency is also facing heat from strong foreign debt outflows and rising bond yields. With rupiah stability as the mandate, new Bank Indonesia governor Perry Warjiyo voted to front-load policy tightening by raising the benchmark rate twice in May. The government affirmed its commitment to fiscal deficit goals, despite upcoming elections.
India faces similar pressures, even if the economic realities differ. The economy’s oil dependence and twin deficits have led the rupee to emerge as the worst-performing currency this year. In recent days, a pullback in global oil prices and lower US rates have stabilised domestic markets, but the jury is out on whether this will sustain.
Undeniably, even at $70 per barrel, oil prices are still 25% above last year’s average. The US has also clearly demonstrated that conditions will be tightened further if inflation persists. This suggests that India’s move to set its house in order should continue, despite external compulsions. On all macroeconomic metrics, the economy is far better than it was in 2013. The current account deficit has halved, fiscal consolidation continues and the adoption of the flexible inflation targeting regime has ensured that policy decisions are consistent with end goals. Inflation has also corrected, from above 9% in FY13, to a likely 5% this year. Between the second half of FY2013 and the first quarter of FY19, India’s foreign reserves stock increased the most among Asian countries, building a defence against external volatility. Depite recent outflows, the balance of payments does not face a funding crunch similar to the one in 2013. Policymakers were prudent to limit the scale of rupee appreciation last year, instead building the reserves buffer. There are some matters of concern. Prima facie, the need for interest rate defence to shield the currency is low given the bigger presence of foreign equity rather than debt investors. But an argument can be made that a pre-emptive, rather than a reactionary hike, is preferable.
Firstly, headline inflation is within the target, but the core is close to the upper band of the 2-6% target, requiring the central bank to act to reinforce its price stability mandate. Besides policy tweaks such as the MSPs, the sharp and quick upmove in crude prices and rupee weakness risk hardening inflationary expectations. Secondly, the likelihood of a wider fiscal deficit, given risks of fuel excise duty cut, uncertainty over GST collections and softer divestment proceeds, is also a concern. Domestic interest rates have hardened as the post-demonetization surge in liquidity petered out. The cost of five-year triple-A paper has risen from 7.6% in December to 8.5% in May 2018 and that of 10-year paper from 7.9% to 8.5%. Short-term rates have also risen—a three-month commercial paper rate is now up 50bps since late-2017.
Money markets can potentially get a boost if RBI infuses liquidity through bond purchases under open market operations; however, it has held back since the first tranche on 17 May. Maturing forex forwards and higher government spending should add to liquidity, but with a lag. This has raised speculation on whether RBI is asserting its anti-inflationary stance through hardening in borrowing costs, rather than an outright policy tightening. Regardless, we see reason for RBI to tighten policy this year, with markets largely agnostic on whether the move comes in June or August. The need to contain volatility and high core inflation provides RBI with the justification to deliver in June. Else, it may go the liquidity route and adopt a hawkish stance, delaying the hike until August. We suspect a hike sooner is better than later.
Radhika Rao is vice-president, DBS Bank, Singapore.