Chief Economist, India,
“The pass-through from exchange rate to inflation is small and statistically insignificant. So RBI does not necessarily need to fight inflation by resisting currency depreciation”
The Reserve Bank of India (RBI) has many challenges on its hands at this juncture — stubbornly high inflation, chronic liquidity shortage, rising financial sector fragility as the local and global economies weaken and a substantial dilution of monetary policy efficacy given the weak fiscal position. The situation has been compounded by the recent depreciation of the rupee, as a year-to-date 14.5 per cent slide has raised investor concern and increased the risk of some pass-through to domestic inflation.
While inflation has been in the nine to 10 per cent range all of this year, it is poised to decline appreciably in the coming months owing to a favourable base effect and likely easing of food prices; but some of the disinflationary dynamic could be hurt by a weak rupee. Diesel and kerosene import costs, in rupee terms, have risen substantially in the past few months, pushing up the fuel subsidy cost and hence the fiscal deficit, which may in turn force the authorities to raise fuel prices.
Under these circumstances, the motion appears to be a worthy one, but we’re against it. Below we argue why:
Impact of rupee depreciation: Regardless of what is causing the rupee’s weak trend, if it poses a major risk to inflation then there would be a compelling case for intervention, especially since inflation has been RBI’s biggest policy challenge in recent years. But India’s inflation dynamic is not appreciably impacted by the rupee. Whether one looks at the consumer price index (CPI) or the wholesale price index (WPI), the fact is a large portion of goods and services consumed by the Indian public is not influenced readily by the exchange rate. Just about all basic food products, many raw material items, a wide range of manufactured goods (for example, processed food, textile and products based on wood, paper, leather and rubber) and services have small import content. Fuel products ought to be far more reflective of the exchange rate movement, but the pass-through is limited as the government chooses to subsidise diesel and kerosene. The data on CPI and WPI, when analysed against the rupee’s movement vis-à-vis the dollar, corroborates this. Analysis of monthly data shows that pass-through from exchange rate to inflation is small and usually statistically insignificant in India. So RBI does not need to fight inflation by resisting currency depreciation.
Causes of rupee depreciation: The fact that India has fiscal and current account deficits is not new, and the ongoing global risk-aversion that has caused emerging markets currencies to weaken in general is clearly not India-related and hence not worth resisting. The question, therefore, is what other factors have been responsible, and if they can be meaningfully reversed or neutralised by central bank intervention. We think that before the latest global sell-off, there was widespread expectation that India would be able to fund its current account deficit through a combination of foreign direct investment, portfolio flows and a variety of short-term borrowing from external markets. Since the exacerbation of the euro zone crisis a few months ago, these expectations have been challenged as external liquidity has dried up. There has also been a growing realisation that the quality of the current account deficit’s financing has become increasingly poor, with greater reliance on hot money. When risk-aversion heightens, portfolio flows become a source of instability. Finally, persistent high inflation has caused India’s real exchange rate to appreciate sharply in the past year, risking the economy’s competitiveness; this can be adjusted downward somewhat through nominal depreciation of the rupee.
Can RBI reverse any of the factors flagged above through intervention? The fiscal deficit and subsidy policy are in the realm of the Ministry of Finance; tightness of external liquidity is beyond the central bank’s control; and the same applies to the size of the current account deficit. If the rupee’s depreciation could not be explained through domestic and external factors, and the exchange rate appeared to be in danger of overshooting in a disorderly manner, there would be a case for intervention, but that is not at all the case now.
We do, however, believe the central bank is capable of intervening credibly in the rupee market. RBI’s reserves to short-term liabilities (on a risk-adjusted basis) ratio is considerably higher than in many other Asian emerging economies. This is, however, not the time to deploy such measures.
Sajjid Chinoy" title="Sajjid Chinoy" class="" />Sajjid Chinoy
“Just as there is a role for central banks to anchor inflationary expectations, there is a role to anchor currency expectations — if expectations are at odds with fundamentals”
Let’s be clear. For all the criticism the Reserve Bank of India (RBI) has drawn on its inflation response, it deserves to be commended on its exchange rate policy — essentially allowing the rupee to float over the last three years.
This deserves to be applauded for the following reason. If India is to grow at eight to nine per cent over the next few years, we are likely to be a current-account-deficit economy that relies on capital inflows. In this scenario, a floating exchange rate is the best shock absorber an economy can have. A negative external shock is likely to induce a depreciation of the currency, which – with a lag – will stimulate exports, depress imports and narrow the trade and current account deficits. In turn, this is likely to stimulate domestic activity and reduce the capital inflows needed for the external balances to equilibrate. It is for all to see what the absence of a shock absorber, in the form of an exchange rate, has done to the Southern European countries.
That said, is the rupee’s recent plunge warranted? From the morning after US debt was downgraded in August, the rupee has depreciated 15 per cent against the dollar. In so doing, it has significantly under-performed the region with the Asian Dollar Index (ADXY) depreciating less than three per cent during this period. As a result both the nominal effective exchange rate (NEER) and the real effective exchange rate (REER) have depreciated more than 10 per cent over the last three months. Undoubtedly, there are important differences between India and the rest of Asia. We are the only current account deficit country in the region and the rupee is deemed “high-beta” in times of global stress. Even so, the underperformance is massive, raising the question of whether the move is justified by fundamentals.
Some of it clearly is. India’s trade deficit has risen sharply in recent months as exports have downshifted while imports – for a myriad of different reasons – remain strong. This has been compounded by capital inflows slowing as global uncertainty stays high. In this environment, some rupee depreciation is both warranted and desirable to play the shock-absorber role discussed above.
The question, however, is whether the currency has significantly overshot driven by expectations and speculative behaviour. By all accounts this seems a key drive. Specifically, India’s exporters have been conspicuous by their absence in the forex market. This is neither new nor novel. Exporters often try to “time” the market by hoarding their dollar receipts in expectation that the currency will weaken. When exporters stay away from the market, but necessary imports, such as oil, generate a demand for dollars in a one-sided, illiquid market, the currency depreciates. This reinforces exporters’ beliefs of further weakness and induces them to stay out even longer, driving the currency into a self-fulfilling weak equilibrium.
I suspect this explains much of the rupee’s behaviour in recent weeks. India’s BoP fundamentals did not worsen so materially so as to justify another seven per cent depreciation in November and even the 36-country REER now suggests overshooting. All this has significantly complicated macroeconomic management, by fuelling inflationary pressures and making the much-needed fiscal consolidation more challenging by causing the oil and fertiliser subsidy bill to surge.
In this environment, there is clearly a role for the RBI to break the self-fulfilling vicious cycle. Just as there is a role for central banks to anchor inflationary expectations, there is a role to anchor currency expectations — if expectations have gotten unhinged and are at odds with fundamentals. And so, while a floating exchange rate is desirable, there is clearly a role for tactical central bank intervention at times like these.
But is it practical – even feasible – for RBI to intervene, given the size of India’s forex market? Should RBI be expending large quantities of reserves to lean against the wind? Will this leave it weaker in the future?
Often, however, a self-fulfilling equilibrium in financial markets – divorced from fundamentals – simply needs a trigger to unwind. If RBI was to begin to draw a strong line in the sand, that might be enough to convince market participants that the rupee has “peaked” thereby unwinding the speculative behaviour. In this scenario, the central bank would help facilitate a mean-reversion without expending a significant fraction of reserves. Given the potential of the currency to further complicate macro-economic management, this seems a gamble worth taking.