It’s credit policy yet again. A surprise cut came our way two weeks back. So what is the street expecting on February 3?
A bigger problem that Governor Raghuram Rajan will have to tackle is the Indian rupee. It has been the strongest performing currency in 2014 and was in December overvalued by 10 percent compared to a basket of 36 currencies that are India’s trading partners. How serious is the rupee overvaluation?
The credit policy expectations poll from economists and bankers shows that hopes of another rate cut from the central bank is rather low now since Rajan announced an out of turn repo rate cut just a fortnight ago.
Just 10 percent of bankers and economists polled by CNBC-TV18 expect a rate cut and that 10 percent expects a cut of 25 basis points then. The majority believe that rates will remain unchanged this time but they see the governor acting post the Union Budget.
55 percent expect Reserve Bank of India (RBI) to announce three more rate cuts in 2015, taking repo to 7 percent by the end of the year; 35 percent expect two more cuts this year while 10 percent see only one more cut coming their way.
A majority also said RBI will lower its consumer price index (CPI) forecast for March to under 6 percent, while 35 percent expect RBI to keep March CPI forecast unchanged at 6 percent; only 20 percent see RBI cutting it to below 5.5 percent.
But more than this, bond markets will be closely watching the governor’s tone and guidance. 80 percent of the respondents expect RBI to sound dovish this time while 20 percent expect him to stay neutral. In fact, the words may be more important than the action this time.
Another pressing problem for the RBI Governor is the rising strength of the Indian rupee.
A brief look at the numbers:
The rupee has been the best performing currency in 2014.
From January 1, 2014, to January 30, 2015, on a spot basis it has appreciated 1.4 percent versus the dollar, while every other major currency has depreciated. This record of the rupee has been partly because of the squeeze on gold imports and the fall in non-oil imports.
India’s current account deficit fell from USD 88 billion in FY13 to USD 32 billion in FY14 or from 4.5 percent of gross domestic product (GDP) to 1.7 percent.
The other reason for the rise in the rupee in 2014 was the rush of capital flows in 2014 because of a strong political leadership.
Equity and debt flows stood at 45 billion from January 2014 to January 2015.
These and other flows could well have taken the rupee to a 5 percent appreciation had it not been for aggressive dollar buying by the RBI.
The RBI is believed to have bought USD 80 billion in spot and forward markets year to date in FY15. If one of half of this was bought in the spot market that is USD 40 billion, USD 40 billion worth of rupees sloshing in the system can be inflationary. So RBI absorbed Rs 60,000 crore or USD 10 billion by selling bonds.
Rupee appreciation may be a bigger headache for RBI in FY16. With a halving of oil prices, the current account deficit may be zero.
If capital flows into Indian equity and debt are again a robust USD 40 billion, the total balance of payment (BoP) flows may be even higher. This will push up the rupee even more. This in turn hurts not just exports, it also makes it cheaper for an Indian shopping online to pick a Chinese good instead of an Indian one thus hurting India’s GDP and Indian jobs.
If RBI buys more dollars, it may increase liquidity which can hurt its inflation control objective. Looks like in 2015, rupee appreciation may upstage inflation as RBI’s biggest headache.
With oil falling from USD 100 a barrel to USD 50 a barrel, Sajjid Chinoy, chief economist at JPMorgan India is expecting a current account surplus for the first time in eight years in the current January-March quarter. He believes the central bank and policymakers will be faced with a significant problem of plenty in the next fiscal year.
“When inflation becomes a problem again and inevitably it is going to happen but that is still far bit into the future, then we have to rethink the whole currency position, the currency stance and start thinking of how currency policy can reinforce monetary policy in terms of fighting inflation,” says Subir Gokarn, former deputy governor of RBI and currently director of research at Brookings India.
Ajit Ranade, chief economist, Aditya Birla Group says if the rupee gets stronger, there is automatically a competitive disadvantage. “I do not think the currency should fluctuate or respond in a volatile manner to capital flows,” he adds.
Below is the verbatim transcript of Subir Gokarn, Ajit Ranade and Sajjid Chinoy’s interview with Latha Venkatesh on CNBC-TV18.
Q: What are you seeing in terms of the current account deficit for the current and next year and more importantly BoP flows?
Chinoy: You have to recognize that with oil going from USD 100 per barrel to USD 50 per barrel, that constitutes a massive positive in terms of trade shock for India. Oil is India’s single biggest import at 5 percent of GDP.
In the current quarter, January to March, we project a current account surplus for the first time in eight years and for next year, even under the liberal assumption that domestic demand picks up and growth picks up and therefore non-oil, non-gold imports pick up, the global economy doesn’t accelerate too much and gold imports pick up because they have been liberalised which is still projecting a current account deficit of only about 0.5 percent of GDP on average for the entire fiscal year which is USD 12 billion.
Given the fact that India’s more stable capital inflow is typically USD 55-60 billion, you are looking conservatively at a BoP surplus of at least USD 60 billion and possibly higher given the magnitude of portfolio flows into India. So the central bank and policymakers will be faced with a significant problem of plenty in the next fiscal year.
Q: Do you also have therefore an estimate of how much the rupee might appreciate?
Chinoy: We think that there will be very aggressive intervention by the central bank in the spot and forward market to try and prevent any kind of normal appreciation for two simple reasons that India even though inflation is much lower the real exchange rate will appreciate just by virtue of the inflation differential. Even if inflation average is 5 percent in India next year, global inflation is running at 1.50 percent, so you are going to get a 3.50 percentage point inflation differential which drives real appreciation.
You will most likely get continued depreciation of other trading partner currencies vis-à-vis a dollar, the euro, the yen. Even if the rupee stays still you are looking at both a normal effective exchange rate appreciation like the time that happened the last fiscal which is going to compound real appreciation. If you have a real appreciation way to 10 percent that won’t board well for the tradable sector so we think Reserve Bank of India (RBI) will do whatever it takes and prevent normal appreciation. There are limits to how much you can intervene and sterilise so we do not project much normal appreciation against the dollar.
Q: Do you agree with Sajjid’s position?
Gokarn: I broadly agree with Sajjid’s analysis. We have to place this in the overall macro context. In a situation when the economy is over heating, when inflation is high, when growth is high and interest rates are being taken up, an appreciating currency reflects and reinforces the overall policy stunts. So, you want demand to be compressed and so it makes sense for the currency to appreciate. We are in the opposite situation now.
In a situation where we can justify the resistances to appreciation in terms of the larger monetary policy stunts which is moving towards the growth stimulus. This of course raises the question of reserve accumulation and the question of sterilisation. When we are looking at trying to grow credit, keep in mind credit growth has been extremely sluggish over a last few months. We are in a situation; we are looking to grow credit.
Sterilisation is not a critical factor. I do not think if you worry too much in short-term over the next 6-12 months about sterilisation because we actually want credit to expand. To the extent that intervention will put more liquidity into the banking system, which is going to stimulate credit growth as well. When inflation becomes a problem again and inevitably it is going to happen but that is still far bit into the future, then we have to rethink the whole currency position, the currency stance and start thinking of how currency policy can reinforce monetary policy in terms of fighting inflation but that is not that challenge, that is not the issue at the moment.
Q: Like I told you it is appreciation of the currency per se by 1.50 percent over the last 13 months. Compared to some of our trading partners it is 10 percent overvalued. As a person representing a business group how bad is it?
Ranade: As Sajjid pointed out, the domestic situation is that we still have an inflation despite it coming down, is at around 8-5 percent. You mentioned the tradable sector. Imagine you are a spare parts manufacturer in India – supplying spare parts to automobile factories in Pune or Chennai and the autos use steel and you sell it to Indian customers, so rupee business, rupee cost rupee revenues but you have to face the possibility of huge imports from abroad especially say steel from China.
If rupee is going to get stronger, you are automatically facing a disadvantage of competitiveness for no reason. I do not think the currency should fluctuate or respond in a volatile manner to capital flows. Especially what Subir was referring if the capital flows are coming into the secondary stock market and the secondary debt market if that is driving currency appreciation we have to be very careful about it? Fundamentally the rupee that domestic currency represents purchasing power of the rupee domestically and this purchasing power cannot be totally out of sink externally and internally. So ideally I would like to see rupee exchange rate which is some what stable.
Q: You were giving us the example of the steel manufacturer who is buying domestic steel and supplying to a domestic consumer but he will get hit because the imported spare part is going to get cheaper. So this is not only exports getting beaten, the local economy will start contracting because it is cheaper to import.
Ranade: The larger part of the domestic economy now is what is called tradable sector so you may not be doing any imports or exports, but you are exposed to the external world. An incidentally the extra dollars that are coming in do not forget that India’s foreign exchange stock is relative to its history it is still low. Meaning there is room to top it up with USD 30-40 billion, so perhaps the Reserve Bank of India can look at its stocking policy of foreign exchange.
Q: So a 10 percent over valuation of the currency compared to a 36 currency basket can be pretty harmful a 10 percent disadvantage for an exporter or for a domestic guy.
Ranade: Why 10 percent, in some of this profit margins in the tradable sector can be as narrow as 5 percent. So, even a 5 percent swing in the currency wipes out your EBITDA, your profit after tax.
Q: Would you say that a continued 10 percent overvaluation of the rupee endangers the current GDP forecast for FY16?
Chinoy: I might take exception to a couple of assumptions there. I think we are implicitly assuming that the rupee is overvalued. I think to come to that conclusion, you have to understand what the fair value is and the fair value is a function of productivity growth in the country, inflation differentials and even the terms of trade shock effects of fair value so our own calculations on this suggests that we are not overvalued, we are in fact very close to fair value. That is number one.
That could change if the real rate appreciates another 10 percent next year then you could be overvalued but that is not the case just as yet.
Secondly, at least the econometric we have done on a sector-by-sector basis looking at different export sectors find that small changes in the real effective exchange rate, you don’t see even with some lag a meaningful change in export volumes for the bulk of manufacturing exports. You do see material price elasticity impacts on service exports but not for manufacturing exports. That is what the econometric evidence suggests and therefore the real rate were to appreciate three-four percent in the next year – I am not sure that is a game changer for our exports. In the last seven-eight months, export realisations have come down but if you backtrack exports volume, there has been no change in that.
Finally, I will just make one more point, we have to look at 2016 in a more general equilibrium sense to extend that oil is a supply shock and boost global growth, we find that India’s new export – Ajit Ranade spoke about automobiles – engineering goods, pharmaceutical goods are very elastic to global demand. So if US growth were to do well what you might find is the impact of that on our manufacturing exports could more than swamp a 3-4-5 percent real appreciation. If you have a larger real appreciation then you do get these non-linearities but let us not jump to the conclusion necessarily that we are 10 percent overvalued just as yet.
Q: What are the tools available for the RBI? Is there a limit to the amount of dollars they can buy, do you think the RBI has unlimited powers to buy dollars? If USD 60 billion or USD 80 billion is the balance of payments surplus, will the RBI be able to sterilise all that?
Gokarn: I go back to my earlier point that sterilisation is an attempt to prevent the purchase of dollars from spilling over into domestic liquidity. You typically do that when you are worried about the runaway credit boom. If you recall during 2003-2007 period when dollars were being bought in large number – there was sterilisation through the market stabilisation scheme (MSS) and yet credit growth was at some point in that period in excess of 30 percent. So even with aggressive sterilisation, sometimes it is a little difficult to get full control over the liquidity flows and their impact on credit growth. That was the time when the economy was growing very rapidly and inflationary pressures were starting to show. We are in a very different situation and I think we have to recognise the differences and the impact of that on policy choices. At this point, I would argue that the compulsion to sterilisation is not that strong. So I think that increases the capacity of the RBI to buy up dollars for the simple reason that if you don’t have to sterilise them all, you are not bound by the balance sheet constraints that you face normally. The MSS can be activated again, it is only dormant, it has not been in terminated, so there is that capacity as well.
Q: In any case just for information, what would be the total balance sheet of the RBI because sometime in 2004, they did not even have enough bonds for repo activities, for LAF activities, is the RBI in that position, what is the total balance sheet now?
Gokarn: I don’t have the numbers in my memory but the fiscal situation for last several years has changed dramatically, the amount of bonds issued by the government is much larger. RBI has been conducting all kinds of open market operations and so on. So I don’t think that we are in the same situation but obviously I haven’t looked at the numbers carefully so I cannot make the judgement.
I don’t think we are in a comparable situation in terms of capacity on the balance sheet per se but we also have created the MSS channel which is an easy supplement to bring into action.
Q: This ability of the RBI to buy dollars and push rupee into the system could be hampered if inflation behaves badly, for instance, if there is a food inflation shock?
Ranade: Currently, the situation is of inflation coming down, so of course it may not come down substantially all the way down below 5 but even if it stays at 5 percent then it is possible to handle the inflows. Remember, the RBI and many other people say defending an appreciating currency is much easier and as Subir Gokarn says that you don’t have to sterilise everything, can leave inflows unsterilized.
Also what Sajjid Chinoy’s point is, let us not be obsessed about exports alone. It is true what he said was our exports are much more sensitive or elastic with respect to global demand and much less elastic to exchange rate. So therefore even if our exchange rate appreciates a little bit, it may not adversely affect our exports if the global demand is improving but the prospect for global demand improving are not that good but let us get away from the obsession of exports, let us look at the entire tradable sector of Indian domestic, nothing as I said – rupee cost and rupee customers that is a vulnerable sector, which gets badly affected with a stronger currency.