We have seen in past that the market has been stunned by monetary policy actions of central banks.
Last fortnight, it was different. The markets stunned the Reserve Bank of India.
The Indian rupee plunged to Rs 74.22 per US dollar. The rupee fell to the lowest value ever in terms of the US currency, which is used for pricing the most important commodity import, namely the petroleum crude. The crude oil imports account nearly for 50% of total imports of India, meeting 80% of India’s requirements. There was a continuing downward in the sliding down of the rupee. On Monday, October 8 it was Rs 74.39, on Tuesday, there were some gains of about 18 paise and it was Rs 73.18.
As I write on Thursday afternoon, it was just recovering after hitting yet another new record low of Rs 74.50 against the US dollar. It was the most undesirable outcome.
Long term concerns
The monetary authorities all over the world anticipate economic prospects much better than markets; and certainly better than the policy making politicians with their myopic view, focusing only on re-election concerns. Central banks take a long run view of things. They centre around domestic price stability (maintaining stability in purchasing power) and external price stability (maintaining stability in the value of domestic currency in terms of foreign currencies, led by the almighty dollar, which is the currency used for pricing the lubricant of the world economy, namely the petroleum crude).
The reserve banks do not worry about the taste of medicine: bitterness or otherwise. In the process, the monetary policy changes affecting the borrowing costs and impact on consumption and investment decisions by households and business houses do shock markets.
RBI’s limited mandate
RBI is more concerned more with domestic price stability; and is not worried about exchange rate stability. Last fortnight, Reserve Bank of India took a monetary policy decision to hold on to the policy interest rate (the repo rate, known as LAF or liquidity adjustment facility) at 6.25%, which affects all borrowing cost, including interest rate called marginal standing facility or bank rate, which was at 6.75%. That surprised the markets, including foreign exchange market.
The business houses and households expected and were also seen reconciled to any likely interest rate rise either by 25 basis or 50 basis points to stem outflows of capital and arresting the downward slide and for maintaining some stability in the external value of Indian rupee.
The market expectations were not unreasonable. The rupee had been falling ever since January 2018 from Rs 61.70/US$ to Rs 71.98 in September. Impacts of the half-hearted attempts of purchasing dollars under the name of market intervention to reduce volatility in exchange rate were weak. The markets legitimately expected RBI resorting ultimately to the right royal way of raising the rate for informing the speculators that the central bank means business.
The case of Indonesia
The central banks in the Southeast Asia have been doing this. Facing outflows of capital, which brought down the Indonesian currency from 10,000 to 15,000 rupiah per US dollar, which was the lowest since the Asian financial crisis of 1998, Bank Indonesia, raised its interest rate five times since May 2018, besides intervening in the foreign exchange market. The government and Bank Indonesia made it clear to the speculators that the monetary authorities would manage the exchange rate and not leave it to their whims and fancies.
Indonesia’s Finance Minister Sri Mulyani Indrawati announced that “Bank Indonesia will certainly keep managing the exchange rate so that we will be able to guard the economy and adjust to a new equilibrium level”
By allowing the currency to depreciate, and allowing the market forces to determine the exchange rate, the markets are made to believe that the monetary authorities would not intervene now for some more time and the downward slide is made to last longer.
In the ongoing currency crisis, initially generated by the trade war by the world’s largest economy and the second largest economy and uncertainties, it is the Indian currency which has emerged as the worst performer, not Indonesia!
After the decision of the Monetary Policy Committee on October 5, the very same day when the rupee crashed and breached the 74 rupees per dollar mark, the RBI Governor Urjit Patel told the press and the nation that the value of rupee is determined by the market forces and the RBI does not have any “target or band” around any particular level of the exchange rate. The reasons behind holding on to the policy rate of 6.25% were that inflation in recent month is well below the RBI target rate of 4% with a plus or minus 2% either side (Table 1).
Certainly, RBI was acting well within the stipulated sphere of its mandated responsibilities.
The question remains: Can or should it not see well beyond the horizon, as the signs were clear.
First and foremost, the rupee has depreciated by 15% since January 2018; the landed prices of all capital goods and the petroleum crude have gone up due to rupee depreciation. Further, the crude price has already risen; and it is forecast to hit $100 per barrel soon due to the world uncertainties in supply associated with the US and Iran conflict. Furthermore, the widening current account deficit (CAD) in an election year would automatically further expand. It is feared CAD would bulge to 5% of GDP from the current estimate of 3%.
The inflationary expectations would be aggravated by bulging CAD and further fall in the rupee value and ultimately inflation.
No doubt, the International Monetary Fund (IMF) in its bi-annual World Economic Outlook (WEO) report, which was released on October 9 after RBI’s monetary policy decision of October 5, has maintained the India’s growth projection at 7.3% for 2018-19. However, the warning issued by IMF cannot be ignored
The IMF’s report WEO says:
“Monetary policy should be tightened to re-anchor expectations where inflation continues to be high (as recently done in Argentina), where it is increasing further in the wake of sharp currency depreciation (Turkey), or where it is expected to pick up (India),”
This warning came in the wake of RBI’s decision to keep the key policy rate unchanged at 6.25%. It is based on an “a benign inflation trajectory and downward revision to inflation projections” dubbing the stance as change from “from neutral to calibrated tightening”.
In the event of a further and persistent downward decline in rupee value, RBI may have to switch to “tightening”. It will have to be sooner than the next scheduled meeting of MPC in December.
— Dr T.K. Jayaraman is an Adjunct Professor, Amrita School of Business, Bengaluru Campus
[The views expressed by the author in this article is his own.]