The volatility in the rupee can only be addressed if the structural problems in the economy are solved, says former RBI governor and current director of research at Brookings Institute, Subir Gokarn. He believes that RBI's measures to arrest rupee fall will work only if there is a parallel plan in place to solve the structural issues such as the high current account deficit.
"If we don’t have a simultaneous movement on structural issues; steps that are actually addressing the causes of the problem, will peter out over a period of time," said Gokarn in an interview to CNBC-TV18’s Latha Venkatesh.
Agrees Arvind Subramanian, senior fellow at the Peterson Institute of International Economics that much stronger actions from the RBI and government is needed to address issues that the economy is currently facing.
Meanwhile, Hitendra Dave, head of global markets at HSBC India warns that the RBI measures also raises the possibility of rate hikes for which the current economy is not prepared.
In a string of measures to tighten the liquidity and bring stability in the rupee, the Reserve Bank of India (RBI) on July 15 announced that it will not allow overnight lending of more than 1 percent of the total deposits (Rs 75,000 crore) in its daily repo window. The additional money will be lent at the marginal standing facility (MSF) at 10.25 percent. It also decided to sell bonds in the open market to drain Rs 12,000 crore.
As a result, bonds fell by about Rs 5 and the dollar rupee fell by 75 paise at the maximum to 59.20. The Treasury bill auction and the bond sales were allowed to be a flop. It raised eyebrows in the market whether the central bank was really resolved to address the problem or was it worried about the collateral damage on the economy.
Below is the edited transcript of their interview to CNBC-TV18.
Q: What is your sense? Is the market now of the view that the RBI does not want to push rates too hard, pay too higher price in terms of economic growth to save the rupee? Or is it going with the view that the steps have been only temporarily rolled back so that the RBI would take even rate rising steps to ensure that the rupee gets a floor?
Dave: There is a fairly sizable reaction in the fixed income markets and the potential for them to create another source of problem. You are trying to address instability in the foreign exchange (FX) markets and are trying to anchor expectations there. But, in the process, you are anchoring rate or yield expectations, when the economy, clearly, cannot be ready for those kind of situations.
It is those thoughts which appear to have reflected in RBI choosing that they want to focus only on the FX market. It is those measures which think they have accordingly tried to help the market with.
Q: What would you expect the RBI to do in its follow through? Purely expectation, not what you want the RBI to do. Since they don’t want to disturb yields too much, would a cash reserve ratio (CRR) hike be the logical conclusion. What are you going with as a market man?
Dave: The last four days tell you that the assumed link between interest rate and liquidity domestic and exchange rate level is perhaps not as strong as it might have been believed while taking these measures. Most market participants will tell you that there is very little onshore speculation which is taking place. Banks are, in any case, controlled by the RBI and the positions are quite micro managed and micro known.
Positions taken through the currency futures market both by banks and by non-banks had been taken care of to certain measures affected two weeks back or so. But having taken these measures, the main signal from the RBI and possibly from the authorities in Delhi, was that we want to anchor expectations vis-à-vis the rupee. It is too soon to say whether it is working or not.
From a market perspective, the fears of further action be it rate, be it liquidity, be it CRR will remain till we see the policy document which will get clarity on what exactly are RBI’s thoughts.
Q: Several central banks have already used the rate weapon to put a floor to their respective standing of the fundamentals in India. Irrespective of what happens to growth in the process, will the RBI need to use the rate hike weapon to ensure that the rupee has first stabilised? Should financial stability be given that utmost importance?
Subramaniam: There are two possible diagnoses. One is to say that all that’s happening is predominantly determined by the external environment notably by what the US Fed has been doing. There doesn’t need to be much of a response. One way of interpreting what the RBI has done is that essentially it is in a thankless job.
For multiple objectives it has only one instrument and it is trying to juggle that. On the other hand, if your diagnosis is that it is actually partly external. But, much more fundamentally, what’s going on in India, and then you would have to step back and wonder whether the RBI was in fact right in pulling back.
If you think the problem is much more India driven, there is a fundamental problem with growth, macro economic stability and really you need much more action from the Indian government and the RBI. Some tightening of policy is unavoidable as that is the way you anchor the rupee.
Otherwise markets are skittish. We are heading into an election year. There is no saying where the floor is going to be. So it really depends upon what your diagnosis is. I would frankly lean towards the latter one. India needs to take much more action to kind of stabilise the rupee and re-engender confidence that things are on track.
Q: What is the sense you would have in a situation like this? Is it very important to first give a kind of financial stability and therefore put a floor to the rupee and should the price of sacrificing some economic growth be paid and rates be hiked, are we in that situation?
Gokarn: We are facing the consequences of a structural problem. The external environment, the announcement by the Fed about tapering was certainly a trigger and it did initiate the process of adjustment that we saw over the last few weeks. But the significance and the magnitude of that adjustment was essentially the result of the vulnerability that we face, we have to know that the size of the current account deficit (CAD) is our biggest indication of vulnerability.
So, when you are dealing with a problem which is essentially structural it is pretty obvious that temporary measures whatever they are and however effective they may be will not address that structural it is pretty obvious that temporary measures whatever they are and however effective they may be will not address that structural problem.
If the measures taken on Monday were a reflection of that to stabilize the rupee in the short term by directly impacting the supply of the rupee, which makes it scarcer and presumably more attractive, these can only work if there are clear signs that the structural problems are also being dealt with.
If we don’t have a simultaneous movement on structural issues; announcements (steps) that are actually addressing the causes of the problem – the vulnerability will affect such measures however strong they may be will peter out over a period of time. That is the risk that we have to deal with.
Q: Has the time arrived to hike rates for the moment, to probably even take out some demand in the medium term from the system, and kill growth a little more and show the resolve to protect the currency? Have we reached that stage of raising rates?
Gokarn: I am constraint from making specific recommendations or predictions on policy action, particularly monetary policy action. So, I will not do that. However, we can make a assessment of the pros and cons of different measures.
The short term issue is liquidity. We are suffering a shortage of dollar liquidity, there is no question. There are two ways to change that situation. One is, as you are arguing, by raising the rates. You want to move along the supply curve by raising rates that is you are inducing dollar inflows by offering higher rates; that is one way to do it.
The other way is to shift the supply curve which is at the same rate, find ways to get more dollars into the system that then opens up the possibility of various other measures, a lot of talk about bond issuance whether it is short term, long term, perhaps there are bilateral options; we have a line of credit with Japan perhaps multi-lateral options.
There has been occasional talk about approaching the IMF and so on. It hasn’t gained much traction, but when we look at the realm of possibilities that we have to address, even from a short term perspective, we should not be confining ourselves to only one action. We have to consider the pros and cons of either moving along the supply curve or shifting the supply curve out.
Both of them will have pros and cons, collateral implications. Let us think it through, before we make a decision.
Q: Having shown the resolve to tighten liquidity as much as possible, to draw a line in the sand in terms of putting a floor to the rupee, perhaps the Reserve Bank of India (RBI) erred in not following it through completely. What stopped the RBI on July 16 – the day when the measures kicked in to go ahead and intervene, ensure that the rupee went to perhaps 58 something – south of 59, scare the daylights out of exporters perhaps who would have thought that they lost a golden opportunity, just seen the measure through rather than leave at the moment a feeling that things are half baked and actually the central bank is floundering?
Dave: I would tend to respectfully disagree with you there. I don’t think the central bank should be in the business of scaring the daylights out of speculators whoever that person be or trying to terrorise the exporters into selling their dollars or whatever. RBI actually did the right thing; recognizing fairly early that perhaps there isn’t as much use of domestic liquidity in the short term which is feeding long dollar positions.
There is obviously a linkage. You keep interest rates high enough which reflect then through the implied interest rates in the forex market or forward premium. For example, if you keep interest rates at 20 percent for one month and the base rate 60/USD, then 20 percent for one month is Rs 1 per month. Then at that level of forward premium, possibly exporters will rush in to sell, importers will be deterred from hedging and that is about it.
So, the focus at this juncture rather than scaring away people from doing this or that has to be – if you recognize that the collateral damage is turning out to be significantly disproportionate to the intended benefit it is better to self correct rather than just say we have taken a decision.
Q: For the longer-term steps or slightly medium-term steps, to bring in the capital flows to fill the current account deficit (CAD) is sovereign bond issue an option? The experience was pretty unsavory in Latin America. What would be your own sense? As it is the total amount of external debt as a ratio of reserves has become uncomfortable; it is USD 390 billion external debt to about USD 290 billion of forex reserves. Should the government go down that path and look for a sovereign bond option at this juncture?
Subramaniam: I have a very strong view on this. I am against all these short-term measures to increase borrowing for one very simple reason that since the global financial crisis at every point that we have had a problem with the rupee and concerns about macroeconomic vulnerability, we have consistently opened the capital account including through higher borrowings, higher foreign flows. Every time you do that, it actually increases the vulnerability down the road.
This short-term measure will cost us very badly in the medium-term and long-run. I would much rather explore alternative ways in the short-run financing the current account including drawing down reserves, raising interest rates. But the irony of this is that the big lesson we have learnt after the recent financial crisis in Latin America, Asia, and Eastern Europe in this crisis. Unfettered flows of capital are very costly and yet consistently we have gone against that lesson and opened the capital account all in the name of saying “Oh, my god! We need to borrow, we need to finance the current account.”
Every time that increases our vulnerability in the medium-term. And every time we open the capital account, and we have a problem like the rupee depreciating is part of the adjustment mechanism for improving the current account deficit, that has to happen and that has happened. But the more you borrow, the more the rupee depreciation undermines the adjustment because you have all these foreign currency borrowings, your debt balloons, debt service balloons and that undermines the efficacy of the exchange rate.
So opening up even more the capital account via more borrowing, via foreign bond issues is very much the wrong step and systematically goes against what we have learnt from the spate of financial crisis over the last three decades.
Q: What is your sense? Should we go for a sovereign bond?
Gokarn: I think that Arvind’s concerns and his warnings about enhancing vulnerability are completely valid. I have the same concerns. We have already seen the short-term debt indicators rising to a point where you start getting little worried about the level of protection you have against a massive exit. We have to keep that in mind.
But there are situations in which you really have no options, but to borrow and the situation arises both in individual household scenarios, corporate scenarios, or national scenarios. If we are in one such situation, the issue is if we have to borrow to deal with what could be a short-term liquidity problem, liquidity crunch.
What do we need to do to assure both the people who are lending money to us and people who generally speaking in terms of our capacity to ensure that we don’t get into an even stickier situation. What do we need to do to ensure that?
And come back to those structural issues. Now nobody is arguing that we can correct the current account or the fiscal deficit situation in one swoop overnight.
But the signalling is very important and whenever we do something that sends the opposite signal that we want to borrow but at the same time we are not prepared to tighten our belts, that makes the cost of borrowing both in direct and indirect terms that much more onerous. If we look at the logic of structural adjustment, whatever views you may have on multilateral source and so on, the bottom-line is when you borrow from a multilateral there is a condition.
It is essentially addressed at dealing with the structural problems that took you to that situation in the first place, now that is logical. Unless we start signalling that we are willing to do that in some credible way the cost and risks of expanding borrowing are very high, but if we are willing to do that, then I think borrowing maybe a way to go in terms of dealing with the immediate pressure of liquidity. But it is a package, you cannot look at these as components and say we will do one and avoid the other.
Q: Since the debate in India is almost narrowing down to an NRI bond or a sovereign bond, what would your preference be? Would it be for an NRI bond?
Gokarn: I think if you believe that the NRI bond, at least has some component of people who are relatively sticky or maybe I will use a slightly more polite word like loyal then you have got a better prospect in the NRI bonds.
Q: There are philosophical arguments against doing a sovereign bond all together. Dr Bimal Jalan completely bashed that he would not go that way at all.
Gokarn: I was going to make the point that NRI bonds are essentially arbitrage opportunities. If you are an NRI who is entitled to invest in NRI bonds, nothing stops you from borrowing from somebody else who isn’t and so it is the difference. So let us be realistic about the arbitrage.
It is universal force; everybody will exploit it so in terms of labeling, I think the issue is not as significant. There maybe some logistic issues, benefits to doing NRI bonds. But to me the channel is not that critical. It is the context in which you place that issue if it is done and that context must be looked.
We are borrowing this money for certain period of time but here are the 10 steps that we are taking as of now, committing to do to address the basic structural issues that got us to the situation in the first place.
If we don’t do that then I think bond is simply going to do exactly what Arvind Subramaniam has described and it increases the risks very significantly.
Q: Would you think that an NRI bond will be largely cannibalizing existing NRI accounts already? Or do you think it can get you some extra USD 15-20 billion or would that be a very costly experiment?
Dave: Any fund raising, I agree should only be announced once almost a war on the current account has been declared with tangible measures which the world starts believing in. If what you have done to gold has worked, identify other items, electronic goods, fancy food items, outbound tourism whatever, anything whether it is a financing package, whatever else, should be done only after that.
So, the cost is lower and it sends out a greater and a much more powerful signal. As far as the bond issue itself is concerned, if the decision is to go down that path it should only be done when the amount to be collected is expected to be double digit billion. So, anywhere between USD 10-20 billion nothing smaller because you really are trying to totally anchor currency expectations and an amount smaller than that may not achieve that.
So, with these two things and to the point the arbitrage it is a totally valid point that if you want this size of money you will have to have an element of leverage within that. Now whether that leverage is obtained by the NRI from a non-NRI or from a financial institution those things one will have to see.
Subramaniam: In terms of NRI versus sovereign to me, the more important point is that however we raise this money, it has to be rupee denominated liabilities. It should not dollar denominated liabilities that is the key touch stone for me. That is the kind of smaller point.
The bigger point, I agree, with what Subir and Hitendra said. But think about it this way; if you in fact commit to a package that addresses the fundamentals both substantively and as a signaling device, then may be you wont need to borrow that much too. I would turn the logic a little bit on the other side and instead of saying we need to borrow, but the borrowing is okay if we enact all these things, I would go just the opposite and say if in fact we can put together credible package may be we don’t need to borrow that much.
It is not as if we are in a crisis in terms of we can't honour our obligations. There are huge rollover obligations. Luckily we are not in that situation. So, if we can do the fundamentals may be the need to borrow is actually attenuated to some extent.