Geopolitical risks and monetary policy

Central banks need to factor in geopolitical risks before they materialise, not treat them as a sideshow

Last May, the rupee came under pressure, rising above 96 to the dollar. In June, the Reserve Bank of India announced several measures to facilitate concessional swaps for foreign inflows, notably through the foreign currency non-resident (Bank) or FCNR(B) deposits. The expectation then was that these measures would result in inflows of around $50 billion and help ease the pressure on the rupee.

 

Your columnist had argued at the time that, given the outlook for oil prices and foreign institutional investor (FII) outflows, the inflow of funds under the RBI schemes would not suffice. A rise in the policy rate was inevitable. The inevitable has happened. The Monetary Policy Committee (MPC) opted for a 25 basis points increase in the repo rate on October 7.

 

The inflows under the RBI’s special measures amounted to a staggering $143 billion. Yet the rupee trades now at around 96.79 to the dollar. After a two-month hiatus, the exodus of FII funds resumed in September with net outflows of $6 billion.

 

The economic environment has changed materially in two respects since June. The price of crude oil has gone up from $85-90 to over $100 now. This is the price of oil futures. The market price of crude futures does not reflect the landed cost to India. The government’s chief economic advisor says that the price of India’s oil import basket is $114 today. That is an increase of 61 per cent over the average price of $71 in FY26. We now face oil prices well above our comfort range.

 

The second factor is the decision of the United States Federal Reserve last month to raise the policy rate by 25 basis points. The betting is that more rate hikes by the Fed are in the offing as inflation in the US remains above the target. 

 

Any rise in Treasury yields affects India in two ways. One, it results in an exit of funds from emerging markets in general, which causes the rupee to depreciate. Two, it results in a narrowing of the yields on 10-year bonds in the US and in India. At 195 basis points, the difference in yields on 10-year government bonds is at its lowest in five years. This factor, too, contributes to the downward pressure on the rupee.

 

The RBI does not wish to defend any particular value of the rupee. Nevertheless, it has to respond to a sharp depreciation in the rupee because that can stoke domestic inflation.  The measures announced in June have not been able to contain the rupee’s depreciation. They ended up creating surplus liquidity in the system, about half of which has since been mopped up by the RBI. Surplus liquidity in the system renders the transmission of rate hikes that much more difficult.

 

Thus, by deferring a rate hike in June and August, the RBI is now having to deal with several issues: Higher oil prices, surplus liquidity, higher US Treasury yields, a narrower differential between long-term yields in the US and India, and a continued exodus of FII funds. A pre-emptive hike in the policy rate would have made its job easier. It would conceivably have eased the requirement for intervention through dollar sales in the foreign exchange market.

 

Monetary policy is said to be forward-looking. However, there is a serious limitation to how “forward-looking” is understood today. Central banks (and international agencies) tend to take a view on the economic situation, outline a baseline forecast and say it is subject to “geopolitical risks”.

 

In a world in which geopolitical risks are pretty much the norm, such an approach will not do. Central banks cannot afford to react to geopolitical risks — wars, sanctions, trade conflicts — after these have materialised. They will need to factor geopolitical risks explicitly into monetary policy, not treat them as a sideshow. How long will conflicts stretch out? What would that mean for energy prices and supply chain disruptions? Central banks need to ask and answer questions such as these in conducting monetary policy.

 

In June and August, the questions that needed to be asked were: One, does the US-Iran conflict have a reasonable chance of resolution? And, two, if it does not, what does that bode for oil prices? The answers should have been clear enough. The Iranian and American positions on the core issues were (and still are) so far apart that there was little chance of an amicable resolution. And that meant the continued disruption of oil supplies and an inexorable climb in oil prices to well above the $85-90 range. The implications of oil prices rising above $100 and staying there should have been factored into monetary policy.

 

Central banks need to create a Strategic Affairs unit that includes people with expertise in international relations, defence studies, the energy sector and economics. The idea is not to replicate the work done in ministries and intelligence agencies. Central banks cannot be in the business of forecasting wars. Rather, the unit must liaise with the concerned agencies and obtain and process geopolitical intelligence relevant to maintaining economic stability.

 

Central banks know how to respond if there is a major disruption that causes oil prices to rise to $120. What they need is a distribution of probabilities about the disruption. The MPC would have before it, say, a baseline forecast of oil prices of $85-90 per barrel with a 30 per cent probability that oil prices would rise to $120 following a major disruption in the Strait of Hormuz. It would then be better placed to judge whether a rate hike and the associated sacrifice of growth are justified.

 

The distribution of probabilities is precisely what the Strategic Affairs unit would seek to determine. The unit would convert the assessments it receives into scenarios for oil prices, inflation and exchange rates with probabilities attached to each scenario.

 

 The RBI’s biannual Monetary Policy Report provides fan charts for inflation and gross domestic product  growth, indicating a range of outcomes. These are statistical probabilities based on historical modelling. What is required is scenario-building for current geopolitical risks of the sort outlined above.  Creating a Strategic Affairs unit would signal to the world that the appreciation of geopolitical risks has moved centre-stage at the RBI.  

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 ttrammohan28@gmail.com