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Opinion | Just how unorthodox RBI can become

We need to examine how far RBI can deviate from the classic wisdom of not taking on market risks

Rewind to the summer of 2013, as the world experienced the seismic effect of a mere mention by the US Federal Reserve’s chairman of unwinding its monetary expansion. The term “taper tantrum" was coined for emerging markets, as if they were being unreasonably petulant. In India, it was full-scale rupee panic by mid August. It had already been clubbed as one of the “fragile five" economies. India was very vulnerable and comparisons with the crisis year of 1991 were unavoidable. The year past had recorded just a 5% growth, the lowest in a decade. Inflation was running at nearly 14%, having stayed in double digits for a couple of years. The current account deficit was past the danger mark of 3% of gross domestic product (GDP). Oil prices were spiking, the Sensex had dropped steeply and, to top it all, the rupee had lost more than a fifth of its value against the dollar in just two months. The government and the Reserve Bank of India (RBI) were in panic mode. There was severe monetary tightening and import duty on gold was hiked to 10%. Easy dollar outflows were crimped and banks banned from taking proprietary positions on currency derivatives. A less known reversal was the reimposition of capital controls on outbound remittances by resident Indians.

It still seemed that the rupee was in free fall and we were headed for a full-blown currency crisis. India’s chief economic adviser Raghuram Rajan shifted base to Mumbai as the incoming RBI governor.

In the midst of it, an unorthodox weapon was brought out. RBI offered foreign depositors protection from rupee depreciation if they were willing to bring in dollars for a tenure of three years. The protection was actually subsidized insurance and covered half the cost. Rajan later revealed that he thought it was a crazy idea to offer an exchange rate cover to investors, but went along reluctantly.

It worked like magic. The country received around $40 billion in Foreign Currency Non Resident (FCNR) deposits, the exchange rate stabilized, stock markets recovered, and the current account deficit reduced. In less than nine months, a new government was swept into office with an absolute majority, oil prices had crashed by 60%, and the rupee strengthened against the dollar. Three years after the announcement of that partial-protection FCNR scheme, when it was time to reimburse the cost, RBI actually made a profit. The gamble had paid off. The central bank had uncharacteristically bet on currency movement, and even implicitly put taxpayer money behind the bet.

The reason to recall that episode is that RBI has done something similar again. There is no “taper tantrum" or rupee panic now, of course. The current account deficit is very comfortable and so are foreign exchange reserves.

So what was the motivation to twice do a dollar swap of $5 billion each?

By buying dollars now, to be swapped back to the seller three years hence, the central bank has not only taken on exchange rate risk, but also credit risk on the counter party. If the bet goes badly, RBI will have to dip into its rupee reserves (read taxpayer funds) to buy expensive dollars to settle the swap. Of course, as RBI sets domestic interest rates, which influence the swap deal, and can partly influence the exchange rate, through intervention, this is an asymmetric bargain.

Yet, one can’t help but recognize it as quite unorthodox. Ostensibly, the aim is to inject liquidity, which had dried up in the aftermath of Prompt Corrective Action against a dozen banks, general reluctance to lend because of the burden of non-performing assets (NPAs) and, finally, the credit freeze following the Infrastructure Leasing & Financial Services mess. There was pressure on RBI to do something even more unorthodox—directly inject liquidity into non-banking financial companies (NBFCs) by refinancing their commercial paper, as banks had stopped doing so. Why not support at least AAA- or AA-rated NBFCs? So went the chorus. This had precedent in the action taken by the US Federal Reserve on a momentous weekend in September 2008. The unorthodox had become mainstream for central banks on both side of the Atlantic after the Lehman Brothers crash. Even RBI itself had quietly given a backstop facility to Indian mutual funds facing redemption pressure in November 2008.

So what’s so unusual in helping NBFCs that are in dire straits now? Is it not better to be pragmatic than blindly principled and orthodox? Except that this is a slippery slope. If it is funding NBFCs today, it could be providing relief to the power sector tomorrow, as this too is reeling under NPAs, after all. Next could be the aviation and telecom sectors. Would full monetization of the fiscal deficit then be far? Some of this may already be happening in the developed world under the name of “modern monetary policies".

However, short-term expediency can diminish the long-term credibility of a central bank. The reputation of such an institution is both hard-earned and precious, but fragile enough to deserve special attention and protection. It is in this light that one needs to examine how unorthodox RBI can become, and how far it can deviate from the tried-and-tested wisdom of not taking commercial risks and not dipping into the fiscal kitty.

For now, three years later, maybe RBI will have the last laugh on its rupee-dollar swaps

Ajit Ranade is an economist and a senior fellow at the Takshashila Institution

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