Nobel Prize-winning economist Paul Krugman once said that if he were to be reborn, he would want to be a bond dealer. It is these very investors who have been part of the clamour for the Reserve Bank of India (RBI) to raise interest rates, which did not happen after the last meeting of its monetary policy committee (MPC) on October 5.
In July 2013, when the rupee last went into free fall following the US Federal Reserve announcing a “tapering” of its $70-billion-a-month bond-buying programme, the RBI had responded through desperate liquidity tightening measures. While the basic policy short-term “repo” lending rate was retained at 6.25 per cent, banks could, however, borrow only up to 0.5 per cent of their deposits through this window. For borrowings beyond this, they had to access the central bank’s marginal standing facility, whose rates were sharply increased from 8.25 to 10.25 per cent. Further, banks were made to maintain 99 per cent of their fortnightly average cash reserve ratio requirements on a daily basis, which was again unprecedented.
The contrast cannot be more with the present times, where the rupee has fallen from 63.87 to around 74-to-dollar since the start of this year (during the “taper tantrum” period, it had plunged from Rs 55.04 on May 21 to 68.36 on August 28). That the RBI is doing nothing has irked the financial markets. In much of the Narendra Modi government’s tenure, the criticism against the central bank — including from the finance ministry — was over its keeping interest rates too high and stymieing an investment recovery. But in the last 10 days or so, that has changed to not hiking interest rates like it did in 2013.
So, what has changed?
The one thing that’s different today from 2013 is the influence of “bond vigilantes”. During the four years from 2014, foreign portfolio investors (FPI) cumulatively bought $80.55 billion worth of stocks and debt in Indian markets. Significantly, of this, as much as $50.3 billion constituted debt (government securities and corporate bonds) and only the balance $ 30.25 billion was equity.
These investors had a good time in this period. With ultra-low global interest rates and a stable rupee, there was a lot of scope for what in financial market jargon is called “carry trade”. Even a year ago, yields on 10-year US Treasury notes were just around 2.25 per cent, whereas it was 6.75 per cent on Indian government bonds of the same tenure. The easiest thing to do, then, was to borrow at the low global rates and invest in a sovereign asset that, in this case, gave a 4-4.25 per cent extra return even after factoring in 0.25-0.5 per cent cost of hedging against currency depreciation. The RBI’s hawkish inflation targeting policy kept interest rates artificially high, while attracting FPI flows into debt. This was further reinforced by a stable rupee, which guaranteed a 4 per cent dollar return.
But like all good things that have to end, this party, too, could not have gone on forever.
The end has come from two sources. The first is global interest going up with the US Fed and other major central banks deciding to “normalise” their monetary policies. Ten-year US Treasury yields are now roughly 3.2 per cent. The second is hardening global crude prices, which have brought back the spectre of current account deficits in India’s balance of payments. That, together with capital outflows from emerging market economies due to a strengthening US economy and the Fed raising interest rates, has resulted in weakening of the rupee. While yields on 10-year Indian government bonds may have also gone up to under 8 per cent, FPIs have no assurance of a stable dollar-denominated return they enjoyed during 2014-17. No wonder, in this calendar year, they have already made net sales of $12.4 billion in Indian equities and debt, of which $8.2 billion is in the latter.
The question remains: Why has the RBI not jacked up interest rates this time, unlike in 2013? The reason is that in the last currency crisis episode, India was also facing near double-digit inflation. Annual consumer price index (CPI) inflation in July 2013 and August 2013 was 9.79 per cent and 9.98 per cent, respectively. The central bank had every reason, then, to raise interest rates, irrespective of whether or not the rupee was weakening. By comparison, the latest CPI inflation rate readings for August and September 2018 are just 3.69 per cent and 3.77 per cent.
It can still be asked what stops the RBI from acting once again to defend the rupee against speculative attack — using monetary policy and interest rates as a tool in exchange rate management. That is a vexed question.
Duvvuri Subbarao, RBI governor in the taper tantrum months, recalls in his memoir: “It is not lightly that a central bank, particularly the Reserve Bank would use its monetary policy weaponary for exchange rate defence. For sure, the Reserve Bank’s regular monetary policy decisions, calibrated with other objectives such as inflation and growth in view, would have an impact on the exchange rate, but that is an incidental, albeit considered, by-product. Directly deploying monetary policy to manage the exchange rate itself is an altogether different ball game.”
That dilemma is, perhaps, far less today where the RBI is primarily an inflation-targeting central bank. When CPI inflation is running well below its target of 4 per cent, why should it raise interest rates? Even when it comes to the rupee, it needs to be borne in mind that the latter’s trade-weighted “real effective exchange rate” — which is against a basket of 36 currencies and adjusted for underlying inflation differentials vis-a-vis the countries concerned — appreciated by 16.6 per cent between April 2014 and December 2017. It has since depreciated by 8.7 per cent till September, but the rupee is still stronger by 6.5 per cent in real effective terms from the time of the Modi government assuming office.
Yes, the RBI should intervene to ensure no undue volatility in the rupee, including by selling dollars from its reserves, so that speculators don’t mount one-way bets or exporters delay bringing in their earnings. But that is different from steeply hiking interest rates for firms and households. A long overdue correction in the rupee will ultimately help Indian industry, farmers and other small producers. No central bank or sovereign should be obliged to bond vigilantes, leave alone allowing them to make a killing even on exiting their investments.