Markets are eagerly waiting for a glimpse into the monetary policy framework of the new RBI leadership team
Never has a Reserve Bank of India (RBI) review met with as much anticipation as the one on 20 September. The new RBI governor Raghuram Rajan has boosted sentiment and excited markets with a slew of financial reforms on his first day in office. Now, markets eagerly await a glimpse into the monetary policy framework of the new RBI leadership team.
To be sure, market expectations are all over the map. Some believe a substantial rollback of the tightening is imminent; others fear decisive rate hikes are on the cards. Some believe the worst is over with the rupee. Others believe this is a temporary respite.
Before evaluating RBI’s options, it is important to understand the backdrop. As feared, the sharp rupee depreciation has imparted a stagflationary shock—pushing up inflation (the annualized momentum of wholesale price inflation is now above 10%, in part, because of the rupee pass-through) while simultaneously impinging on growth by reducing purchasing power and stressing corporate balance sheets. More generally, growth impulses remain weak. The momentum of gross domestic product (GDP) in the second quarter of 2013 slowed sharply and both PMIs (Purchasing Managers Index)—services as well as manufacturing—are well below 50, suggesting momentum continues to slow. How should RBI react to a stagflationary shock?
There has been unambiguously good news on the rupee which seems to have broken out of a vicious, self-fulfilling spiral over the last fortnight. A combination of domestic events (the new governor’s focus on financial liberalization, creation of an oil swap window, more banking capital) and global good fortune (soft US payrolls number and a diplomatic resolution in Syria) have combined to deliver a sharp mean-reversion to what was obviously an undervalued currency.
So, how should RBI respond? Given weak growth and signs of a stabilizing currency, should the tightening measures be unwound? The central bank appears unlikely to take such a gamble. Policymakers have had to engage in a fierce firefight over the last two months to break the rupee’s vicious spiral. It appears unlikely that they are ready to risk hard-earned gains by completely undoing the liquidity tightening measures—especially when part of these have accrued due to a more benign global environment, which could easily reverse. Doing so would signal that either its foreign exchange objectives have been accomplished or that the currency is no longer the burning priority—and either of these messages could unsettle the foreign exchange market.
What about a partial rollback? That is possible, but the signal is still important. The interest rate defence was never about the quantum of the increase. A 300 basis points (bps) increase in annualized rates (i.e. less than 30 bps on a monthly basis) was never going to be sufficient deterrent against a currency that was moving 100 bps a day. One basis point is one-hundredth of a percentage point. But it was a signal to markets that policymakers believed the currency had undershot and they would not turn a blind eye to further weakness. It could be important to sustain that message for a while longer.
To be sure, with growth momentum so weak, these emergency measures cannot go on forever. That said, the sharp real depreciation of the currency against a backdrop of firming global growth suggests that monetary conditions, more generally, are not as tight as suggested just by the level of interest rates. So it’s likely the central bank will want to more fully ascertain that the rupee has stabilized, expected capital flows are materializing, and global risks are fading before beginning any rollback.
Furthermore, if and when a rollback does occur, it may be accompanied by some increase in policy rates to ensure that the entire tightening is not reversed. Besides, this will also combat rising inflationary pressures. More fundamentally, with global rates on the rise and the US yield curve steepening sharply, it’s hard to imagine that India’s yield curve can remain so flat for long in any new equilibrium.
All told, the central bank is likely to leave this one outside the off stump. Instead the governor could well propose new initiatives to further reform, liberalize and deepen forex and money markets—something that he has long advocated and could have a long standing impact on India’s financial development and potential growth.
There is no end to the market clamour for focusing on growth but it is questionable whether easing monetary policy— given binding supply constraints on the ground—will have the desired efficacy on investment. More fundamentally, a return of macroeconomic stability will have to precede any growth pick-up. There is finally some good news on that front. The trade deficit has narrowed sharply, the rupee has begun to stabilize, and the government has underscored its fiscal intent. These are all encouraging but fledgling signs. And it’s important not to jump the gun.
Never has a Reserve Bank of India (RBI) review met with as much anticipation as the one on 20 September. The new RBI governor Raghuram Rajan has boosted sentiment and excited markets with a slew of financial reforms on his first day in office. Now, markets eagerly await a glimpse into the monetary policy framework of the new RBI leadership team.
To be sure, market expectations are all over the map. Some believe a substantial rollback of the tightening is imminent; others fear decisive rate hikes are on the cards. Some believe the worst is over with the rupee. Others believe this is a temporary respite.
Before evaluating RBI’s options, it is important to understand the backdrop. As feared, the sharp rupee depreciation has imparted a stagflationary shock—pushing up inflation (the annualized momentum of wholesale price inflation is now above 10%, in part, because of the rupee pass-through) while simultaneously impinging on growth by reducing purchasing power and stressing corporate balance sheets. More generally, growth impulses remain weak. The momentum of gross domestic product (GDP) in the second quarter of 2013 slowed sharply and both PMIs (Purchasing Managers Index)—services as well as manufacturing—are well below 50, suggesting momentum continues to slow. How should RBI react to a stagflationary shock?
There has been unambiguously good news on the rupee which seems to have broken out of a vicious, self-fulfilling spiral over the last fortnight. A combination of domestic events (the new governor’s focus on financial liberalization, creation of an oil swap window, more banking capital) and global good fortune (soft US payrolls number and a diplomatic resolution in Syria) have combined to deliver a sharp mean-reversion to what was obviously an undervalued currency.
So, how should RBI respond? Given weak growth and signs of a stabilizing currency, should the tightening measures be unwound? The central bank appears unlikely to take such a gamble. Policymakers have had to engage in a fierce firefight over the last two months to break the rupee’s vicious spiral. It appears unlikely that they are ready to risk hard-earned gains by completely undoing the liquidity tightening measures—especially when part of these have accrued due to a more benign global environment, which could easily reverse. Doing so would signal that either its foreign exchange objectives have been accomplished or that the currency is no longer the burning priority—and either of these messages could unsettle the foreign exchange market.
What about a partial rollback? That is possible, but the signal is still important. The interest rate defence was never about the quantum of the increase. A 300 basis points (bps) increase in annualized rates (i.e. less than 30 bps on a monthly basis) was never going to be sufficient deterrent against a currency that was moving 100 bps a day. One basis point is one-hundredth of a percentage point. But it was a signal to markets that policymakers believed the currency had undershot and they would not turn a blind eye to further weakness. It could be important to sustain that message for a while longer.
To be sure, with growth momentum so weak, these emergency measures cannot go on forever. That said, the sharp real depreciation of the currency against a backdrop of firming global growth suggests that monetary conditions, more generally, are not as tight as suggested just by the level of interest rates. So it’s likely the central bank will want to more fully ascertain that the rupee has stabilized, expected capital flows are materializing, and global risks are fading before beginning any rollback.
Furthermore, if and when a rollback does occur, it may be accompanied by some increase in policy rates to ensure that the entire tightening is not reversed. Besides, this will also combat rising inflationary pressures. More fundamentally, with global rates on the rise and the US yield curve steepening sharply, it’s hard to imagine that India’s yield curve can remain so flat for long in any new equilibrium.
All told, the central bank is likely to leave this one outside the off stump. Instead the governor could well propose new initiatives to further reform, liberalize and deepen forex and money markets—something that he has long advocated and could have a long standing impact on India’s financial development and potential growth.
There is no end to the market clamour for focusing on growth but it is questionable whether easing monetary policy— given binding supply constraints on the ground—will have the desired efficacy on investment. More fundamentally, a return of macroeconomic stability will have to precede any growth pick-up. There is finally some good news on that front. The trade deficit has narrowed sharply, the rupee has begun to stabilize, and the government has underscored its fiscal intent. These are all encouraging but fledgling signs. And it’s important not to jump the gun.
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