Former deputy Reserve Bank governor and currently research director at Brookings India Subir Gokarn said the proposed unwinding in quantitative easing may unleash adjustments in markets, following which attracting foreign funds may pose a challenge. Equity markets plunged on fears of portfolio outflows after Fed signalled US economy was ready for a stimulus pullback.
India is already facing tremendous pressure of a wide current account deficit and any desire to curb it is seriously obstructed by an ailing home currency. The Indian rupee plunged to its life low of 59.57 to a dollar at close on Thursday.
Speaking to CNBC-TV18, Gokarn said the government needs to take credible steps to tackle deficit, which will help rupee and sentiment in market. Meanwhile, Indian bond prices have fallen further and the 10-year bond's yield have risen by another three basis points to 7.42 percent on suspected FII selling; sentiment is also weak ahead of an auction today and because rate cut hopes have all but vanished. Gokarn, however, said that the RBI may still find elbow room to cut rates in its next policy.
Below is an edited transcript of the interview on CNBC-TV18
Q: Since we last spoke, it has been a steady downward spiral for the rupee. The question a lot of people are now beginning to slowly ask is: whether the macros and the currency set up resembles some kind of currency crisis for us?
A: When we look at what happened last week, it was precipitated essentially by the same set of factors that did yesterday’s damage. That was the hint or the signal from the Fed that the quantitative easing (QE) would be rolled back. Then two days ago that signal was confirmed; it was made explicit.
So you really have to look at this as part of the overall adjustment, both before and after the announcement, to the new liquidity scenario that will emerge once the QE is actually rolled back. So, as people have been saying, there is certainly an overshoot element in this particular adjustment where all global portfolios will first take stock of what the new liquidity scenario will mean for them and then there will be some reallocation, which will lead to some sort of normalization.
Now, the question is: what do you do from a policy perspective to ensure that when that normalization takes place some of those funds are going to come back into your markets? That is the challenge that the policy establishment faces and to a large extent other emerging economies as well.
Q: Last couple of years this problem was there. The current account deficit (CAD) was always large but we just had the comfort of the global liquidity actually putting some kind of a plug on that. Do you think we can do something on the policy front quickly over the next few weeks, which can tell global investors they don't need to take money out of India in their reallocation or do you think this global phenomena will hurt us anyway?
A: That is the key. When it comes to taking specific steps to stem the flow, people will start getting a little tempted to impose some kind of control or the other. Some control on outflows, some control on trade. We need to resist that because these can have very negative long-term negative consequences particularly if this process of adjustment is essentially a short lived one.
However, when the money starts to get reallocated, as I believe it will, what we have done in terms of credible concrete actions to narrow the gap are going to be very critical. We talked last time about the gold issue, the oil issue, about the minerals issue—all of these are pressure points on the current account which can be reversed. At least credible steps can be taken to signal that these pressures will be eased overtime, not overnight. That is very important.
There is some news about a meeting on July 1 to take stock and to put out a time bound action plan. That will be a very critical point at which the signal of commitment and credibility should go out. And if that is established, if concrete time frames are set, if reasonable actions are proposed, when the reallocations happens I think that does provide something of a platform for normalisation take place.
However, if that doesn’t happen clearly than the pressure of the CAD will be seen as a much more persistent and permanent pressure and that can have consequences for the currency beyond the immediate future.
Q: The other thing which people have started debating is: what flexibility the Reserve Bank of India (RBI) has going forward to reduce rates in a scenario where imported inflation, because of the rupee, will go up and the US bond yield has started hardening quite significantly? Do you think the elbowroom is vastly diminished now compared to what it was even a month back?
A: The elbowroom is partly a function of the exchange rate. It is also partly a function of what happens to commodity prices. Now, clearly with the liquidity reversal or the rollback, along with other asset classes, we should expect to see some correction in commodities. There is a general perception that the reason why oil prices are so high even at this point in the business cycle is liquidity, is that it is asset class.
So if there is a rollback then that may to some extent offset the currency dynamics. If the currency readjusts ones global portfolio allocations normalize then there may be some room but both of these factors are going to play a role and they are both moving in somewhat different direction right now. So there is an offset factor there. Overall, if commodity prices remain where they are for whatever reason and the currency continues to slip, then the inflationary consequences of the depreciation have to be taken into account.
Q: What did you make of what happened in the bond market yesterday? Trading was actually halted. Do you think there is a big reset happening in the bond market as well? Where would you say yields could be headed to?
A: I am, at least for a while, not in the projection business. I am not going to make any forecast but what the episode displayed was the vulnerability that you have on the external sector when you open up to debt. We saw a very similar pattern of course over much longer period and with greater intensity during the Asian crisis when the countries that were badly affected had all opened up very liberally to debt flows. Those reversed very quickly and went out in a flood. That had a huge impact on both domestic macro parameters and the currency.
So we have been opening up on debt. Obviously, there were some compulsions for it over the last couple of years because other flows were tending to ease up and we needed the inflows. But when the situation reverses, as we have seen over the last week, those debt flows are the first ones out. So, the money that came in over a period of months went out over a period of days and you get this outcome — the prices crash, the yields shoot up and this has a direct bearing on the currency.
So, what is done is done. We cannot rollback on that, but we have to be conscious of the fact that when we open up to more risky forms of investment, we have to manage our vulnerability. You cannot do this in a situation where the CAD poses such a high level of vulnerability.
Q: Given the current context, both with what's happening with the bond market and EM currencies, what do you think should be the next likely couple of steps to attack the depreciation on the rupee? What two-three steps are of crucial importance now?
A: The signal that has to come out in terms of not overnight and there is no magic wand here that you say something and tomorrow flows are going to come back. We have to prepare ourselves for the readjustment and that means now signaling some concrete steps on the vulnerabilities on the CAD, what are we going to do with gold, what are we going to do with minerals, what are we going to do with oil. There will be some short-term measures but most of these are going to be yielding dividends if they do over a year or more. However it is important to have these plans laid out very concretely and it is not as if there aren’t inputs already available.
The gold issue for example has been discussed repeatedly at various levels and there are proposals out in the public domain. So it is important to commit to some of these at least as a start and then over time flesh out some more. Coal is very significant, iron ore is very significant. These are caught in judicial action. Government needs to have a plan to work through this and we cannot just assume that this is the end of the mineral economy that we cannot ever export iron ore again or we will permanently live with imported coal. I don't think we can afford to take that position. So some strategies to reverse the situation are important and I hope that starting July 1 that some of these problems are concretely addressed.
Q: The news that is coming through from New Delhi also is that the government will look at lot of FDI changes in specific sectors. Do you think these kind of enabling provisions will matter much in the situation that global liquidity is in and that will do anything beyond sentiment to shore up the rupee?
A: Not immediately. I think FDI even in the best of circumstances enabling is important, it is critical but at the end of the day it is the business environment, the business prospects that bring the money in. So it is important to enable and there is no question that these things need to be done if they deem to be acceptable by the range of stake holders that are involved. Then by all means let us go ahead and do that but let us not expect them to substitute for some of the more difficult structural measures that need to be taken.
So it is all part of an approach, they all add up to greater comfort, to greater confidence and therefore help us to position more effectively for the normalization that is inevitable but none of them is a solution in itself which will not allow these kinds of actions to come in the way of the more difficult ones.