A former chief economist for the IMF and one of the few economists to predict the global financial crisis, Raghuram Rajan brings an impressive track record to the governorship of the Reserve Bank of India. Soothsayer extraordinaire he may be, but few analysts rate his chances of being able to pull off the juggling act required to rescue the economy from what is shaping up to be the worst crisis since 1991, when India was forced to airlift its gold reserves to secure an emergency IMF loan.
That crisis ushered in widespread liberalization reforms that opened India’s economy to the world, sparking two decades of growth that catapulted the country to become Asia’s third-largest economy.
Although the causes of the current crisis appear almost identical to those behind 1991 – a precipitous rupee depreciation against a widening current-account deficit – the more striking fact is that India has seen no reforms of comparable significance in the almost quarter century since.
The rupee has actually been in retreat for some time, losing almost 30% of its value over the past two years. Most of the decline has been since May as, in common with other emerging markets, India’s currency has plummeted against the US dollar on fears related to the tapering of quantitative easing, making its large current-account deficit more costly to sustain.
The situation has been exacerbated by three rate cuts in the first half of this year to try to stimulate an economy in which growth in the year to March fell to 5%, its slowest pace in a decade.
Recent efforts to halt the slide by restricting liquidity in the rupee money market to make it more difficult to short the rupee, and selling dollars, have pushed borrowing costs to a five-year high, savaging corporate and investor confidence.
The rupee was changing hands at 64 to the dollar in recent trade, pulling down Indian stocks and sending 10-year benchmark yields nudging 10% as investors worry how low the currency could go. But while Turkey, Brazil and Indonesia have raised rates to try to counter outflows of capital, the RBI has kept its (policy) overnight repo rate at 7.25%, aiming to effect the same result by instead tightening short-term rates by 200 basis points in mid-July.
Two weeks later, at its monetary policy meeting, the RBI hinted it was minded to loosen monetary policy but, when that failed to arrest the rupee’s decline, reverted to tightening talk. This flip-flopping has had a disastrous effect.
Nida Ali, economist at Oxford Economics, says the RBI has drip-fed monetary policy tightening without giving any clarity about its monetary policy stance.
“Communicating to financial markets in such a conflicting way creates a lot of uncertainty and instead of stabilizing the rupee it’s backfired and now India is doing worse than any other emerging market economy.
“Rajan’s first priority would be to stabilize the rupee. So far, the RBI’s measures, instead of restoring stability, have spooked investors by sending mixed signals. He very much needs to restore monetary policy credibility and win back investor confidence by using clear communication to convey his intentions behind the monetary policy stance.
“He is taking office at a very unfortunate time. He can’t shoot a magic bullet and the problem will go away just because of his reputation as a great economist. It may be that financial markets have more trust in him and that could calm the volatility in the market, but the actual monetary policy tools at his disposal right now are limited.’’
If Rajan cuts rates the rupee will slide even further and stoke inflation which, thanks to the weak rupee, is already at 9.6% and rising. Raising, or even just holding, rates to support the rupee will place further downward pressure on economic growth when demand is weak.
Longer term, Ali says India would benefit from inflation targeting instead of the current monetary policy regime of simultaneous targeting of a number of economic variables, and reforms to bring a larger share of the population into the financial system and cut red tape across the financial sector.
The depreciating rupee is pushing up costs of oil and other commodities for which India is heavily dependent on imports, which in turn boosts the current-account deficit and government spending on fuel subsidies, which may widen the fiscal deficit. The current-account deficit hit 4.8% of GDP in the year ended in March, way above the 2.5% the RBI says is a sustainable level.
India does have sufficient reserves for about seven months' imports and the government is working to keep it that way. The RBI has increased the cap on FDI in asset reconstruction companies from 49% to 74%. Finance minister P Chidambaram, to whom Rajan has been an adviser for the past year, has acted to address current-account deficit funding risks, imposing restrictions on gold and silver imports and laying out plans to curb non-essential imports.
But analysts say the measures mostly betray a quick-fix mentality that is woefully inadequate given the seriousness of the problems facing the economy. They point to the derision that has greeted the removal, as of Monday, of the import duty exemption on the flat-screen TVs that Indians often bring home with them from overseas.
The RBI recently reduced the ceiling on the funds Indian residents and companies are permitted to remit or invest overseas, raising fears that capital controls on foreign investors could be next. Global funds have already cut $10 billion of rupee debt from their holdings since May when the US Fed first hinted it might taper.
Foreign investors dumped India stocks and bonds to the tune of $3 billion in July alone, forcing the BSE Sensex to slump below the key 18,000 threshold. However, the pull-back from equities was hardly a sell-off, amounting to just 1.2% of foreign investors’ net holdings, but the fear is that global funds, which move more deliberately, will begin reallocating their holdings of Indian stocks.
“The mixed signals have really taken their toll and it’s not just the central bank governor but the government pushing policies such as its food subsidy bill,’’ says Shweta Singh, emerging markets economist at Lombard Street Research.
“If this lack of a credible policy response continues, Rajan, or any other central bank governor, will have no other option but to hike rates aggressively, not least to avoid a more disruptive tightening by market forces. There needs to be a tighter monetary policy stance. The longer they take to undertake the right steps, the more rate hikes the central bank will have to undertake.
“They had other options, and they still have, but the pace at which the rupee has depreciated has made it unlikely that these other options will have as much of the desired impact as when the rupee was at, say, 59 to the dollar.”
Singh says the RBI could have come out more strongly and earlier saying the rupee will be supported, initiated more rigorous steps to attract foreign investment, not flip-flopped on policy direction, issued sovereign-backed dollar-denominated bonds and raised deposit rates for non-resident Indians more aggressively.
Singh concludes: “The central bank can regulate only the demand side; the supply side is primarily with the government. What it can do is issue more bank licences to create a more competitive financial system so that there’s a better pass-through of monetary policy to the real economy and more surveillance so that loans are not issued to sectors which don’t deserve it.
“On the one hand they’re trying to attract inflows, which is a good way to address the currency pressure, but at the same time they’re trying to put restrictions on outflows, which is quite an aggressive move.’’