Only swift action on CAD can soothe market: Gokarn

India needs comprehensive and realistic solution to deal with the ballooning current account deficit, which is the root cause of all macro woes, believes  former deputy governor of Reserve Bank of India (RBI) Subir Gokarn.

Widening CAD has had a near-fatal impact on rupee, which touched 64 per US dollar, a level never seen before. The home currency's plunge caused the 10-year bond yields to hit a five-year high of 9.4 percent on Tuesday. In a bid to rescue the free falling rupee and bond, the central bank eased cash and bond holding rules for banks. (Read More) But Gokarn finds the measures ill-equipped to tackle the real problem. “The tactical measures taken by the RBI are not addressing heart of problems – the CAD. The pressure will continue till fundamental problems are addressed,” he told CNBC-TV18 in an interview. Given the way India’s macros are shaping up, there is a large threat of a credit rating downgrade by global credit rating agencies. This is what most investors are worried out. Global agency Standard & Poor's has said that it maintain its negative outlook for India. (Read More). Gokarn, who is currently director of research at Brookings India, feels that government and RBI should not ignore rating downgrade risks. “We need to see a dramatic change in monetary policy stance. Only a swift action on CAD can soothe market,” he added. Below is the verbatim transcript of Subir Gokarn's interview on CNBC-TV18 Q: How should markets read the central bank approach to fix the problems over the last 4-6 weeks in conjunction, first the tightening measures and now Tuesday's loosening measures. Do you think market may be quite confused about these conflicting signals? A: The basic motivation for the initial actions four weeks ago was to reduce the supply of rupee to make it more expensive, so essentially stabilising the exchange rate by making the rupee scarcer and therefore, more expensive. At that point the motivation was to try and offset some of the impact of that because inevitably this will result in higher interest rates. You make the rupee scarcer; it will be more expensive at home as well. To offset that some sort of an open market approach to flatten the yield curve or at least prevent the long end of the yield curve from increasing to the same extent as the short end. That did not happen over time for two reasons, one, the FIIs who had large bond exposures, government security exposures were selling off and two because the government is still borrowing very large amounts of money, its standard weekly auctions Rs 12,000-15,000 crore a week. So that made it difficult for the long end rates to be kept down. What is happening now is a response to the way the yield curve panned out in response to the initial moves and now by buying back long end securities reminiscent of what the Fed called Operation Twist focusing the buyback on long end securities trying to bring the long end rates down essentially trying to flatten the yield curves. So there is an internal consistency to this. It should have been done alongside simultaneously, but at this point the objective is to try and insulate the domestic market from the impacts of tightening at the short end.

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Q: Does it befit the central bank to move in almost a trader oriented fashion to put tactical patches wherever the crisis is brewing the hardest? A: To some extent this flexibility in response is inevitable when the short-term measures that are now being used are not really addressing the heart of the problem. The fundamental calls of the rupee dynamic is the current account deficit (CAD), we all expect this, we all know this, we keep repeating it, which means that unless you have a strategy that actually addresses the CAD credibly, nothing else is going to matter. So you can keep playing with short end instruments, actions, responses. You are going to clamp down somewhere. It will show up somewhere else and therefore, the only way to manage it is to be very reactive in dealing with wherever the pressure is building up and that is what is happening now. There is an action addressing a pressure point. The pressure shifts somewhere else. The reason for this is that the fundamental call is not being addressed and the pressure will keep showing up somewhere or the other. So, without comprehensive and realistic strategy for current account management you may just be doing this very tactical, very short-term set of actions for sometime to come. As soon as we see some credible action on the current account the space for using tactical measures as complement to the more strategic actions increases and you are going to see greater consistency and greater clarity in the entire picture.

Q: How have been the recent wins towards the government borrowing target? Is there a fair chance that the government borrowing target for this year will be overshot because of the way currency and global commodity prices have moved with limited pass-through? Are we staring at a situation which may not be manageable? A: You are looking at the irresistible force hitting an immovable object like the currency. We are losing sight of the fact that oil prices have also been quite hard, USD 110 or so on the Brent for quite sometime, so that is also adding pressure and increasing the under-recoveries on diesel now. Even though we have been correcting the gap, it is just running ahead of us. So there is fiscal pressure coming from both the currency and commodity movements and the immovable object is visibly the Finance Ministry's resolve to not let the deficit go beyond the budgeted number. So what we saw towards the end of 2012-13 was very drastic expenditure compression. Any slack, any funds that were available, that had not been used up were frozen. So we still have that option in terms of controlling the Budget deficit going into the next year, it will not be a Budget, it will be a vote on account presumably, but at least the Budget estimates will look consistent or in line with what were projected but that means very sharp reductions in government programs wherever required. There is always certain amount of slack that you can afford to cut, but that means some public welfare programs or infrastructure which is another source of concern will get cut. So it is not just a question of meeting the target, it is doable. But what does it costs when you are running against revenue shortfalls and widening subsidy bills, what part of the government expenditure program is going to get hit and that can have consequences across the board.

Q: We are running close to election, typically a time when the government does not want to cut down on the kind of expenditure that you are suggesting and this time growth is going to be sub-5 percent for a couple of quarters which is then if you cut down this expenditure growth gets hit really badly. On both these accounts, do you think this time the government can reach the fiscal deficit number given these considerations? A: Choices have to be made. There was some relief from the 2013 Budget. When we look back at 2008, then Budget had a lot of fiscal space, but it introduced the loan waiver and so on, basically with an eye on the political trajectory. In 2013 Budget despite being the last Budget before the elections, there was enormous resistance to any temptation to go populist because of the fiscal pressures. Even though there maybe a temptation on the part of some of the political components of government to go for more lavish spending. The concern is with maintaining the deficit and the rating downgrade risk is always in the background. Sometimes it is more visible as things pan out, so that is something the government clearly has to keep in mind. I do not think the idea for the populist bench with the current resources is too much of risk. In any case, I doubt there will be any supplementary demand for grants which is typically how extra expenditures get funded and I do not think that is going to happen this time. So we have to rely on the commitment of the Finance Ministry to meet its targets and in doing so where it reacts is really the question and of course the risk.

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Q: This morning there is some relief for the bond market because of what the RBI did overnight. Given the circumstances that you have just detailed over the last 5 minutes do you think it is unlikely given where the currency is that we will have a loose monetary policy framework for the next 6-9 months? Do you think chances of the market yields remaining fairly high or elevated are higher? A: In any case even before the current scenario evolved late May-early June the RBI was indicating that it was working with very limited room, because the fundamental drivers of inflation, particularly on the food front were still in place. If you extend that argument and take into account both higher energy prices in dollar terms which is also a problem, but more or so the currency impact on cost of all imports inflationary pressures have certainly not eased and more likely harden. Extending that argument means that essentially there is even less room now to ease, but if you are taking a growth-inflation dynamic the fact that growth numbers are also suggesting great weakness does shift the needle a bit towards the growth front. We have a new governor in place, so the paradigm itself will be articulated once the change formally occurs, but it is difficult to say how the inflationary concern will ease with all the things that have happened in the last few weeks. The only thing that they have done is to actually increase inflationary pressures. I would be little cautious about predicting a dramatic change in the monetary policy stance swinging dramatically to growth and forgetting about inflation, because inflation is still very much a risk.

Q: When you cannot manage three things at the same time which the RBI has been trying to do with limited success over the last few weeks, do you focus on just two of those three things and sacrifice one with the object of at least achieving success on two out of three parameters? A: That is what it amounts to. If you articulate your focus on all three, one of them will look like you are dropping the ball. When you have growth inflation and currency, the regime change in July that essentially shifted from the growth inflation dynamic to the currency dynamic is consistent with managing inflation as well. If you have tightened liquidity it is fulfilling an inflation containment objective as well, but what gets hit is the growth objective. So now the trade-off has shifted from inflation growth to exchange rate and growth and to get back to my earlier point this is really not sustainable because unless the current account issues are resolved it is very difficult to sustain this kind of policy even if you have the exchange rate as your primary objective. We have to see some action very quickly and very credibly on the current account and it only that will allow these more tactical measures to become more effective, because they will provide some space. They will calm and soothe markets which will then allow the more structural aspects of the policy to start having an impact. We should be concerned about bringing the two elements together and not just depending on one.