Fed Rate Cut: Does it Matter for India?

The much-awaited moment finally became a reality. The Fed, at last, announced a 50 basis point cut in its policy rate on September 18—the first since 2020—which is momentous for two reasons: one, it marks the beginning of a monetary-easing cycle. Two, it represents the Fed’s belief that inflation is no longer a problem but what matters now is giving a nudge to employment.

The Fed’s rate cut, as anticipated, triggered volatility across asset classes. After the announcement, the United States equities ended lower—S&P 500 ended down 0.3% after rising 1% during the session—which is a historical feature. Some analysts believe that the market has already priced in the rate cut— hence the initial fall in the index. That aside, the spot gold too ended lower in the international market—after touching an all-time high of $2,618 per ounce on September 18, it was quoted at $2,587 on the next day. This is, of course, likely to be a short-lived feature, for a weakening dollar is always found to be advantageous for gold prices to go up.  

But Asian equities recorded meaningful gains. On balance, it is perceived as a positive development for developing economies. Coming to the Indian stock market, its impact may not be that significant, for it has already been attracting investor interest for the last several years, said Chief Economic Adviser Anantha Nageswaran.

Nevertheless, two days after Fed’s rate cut announcement, the BSE Sensex, soaring to an all-time high of 84,694.46, settled at 84,544.31—a rise of 1.63%. Similarly, the NSE Nifty 50, rising by 1.48%, settled at 25,790.95. Although the global macroeconomic factors are currently favoring equity markets, analysts opine that volatility is likely to continue in the equity markets owing to the uncertainty about the upcoming US elections, the ongoing economic slowdown in the US, and other geopolitical factors. 

The rate cut is expected to result in a global rally in debt markets that would likely improve liquidity in the market which in turn can make finance cheaper for businesses. Analysts also opine that the rate cut may also weaken the dollar making US bonds attractive for foreigners. Though the Fed is assuring investors that the US economy is in good shape by calling the move a ‘recalibration’ to stay ahead of any potential weakening in the job market, analysts, fearing that the 50 bps cut is just the beginning of Fed’s fight against likely recession, expect demand for oil to remain stagnant in the Western world and this may keep oil prices slightly tilting southwards. However, the impact of China’s stimulation and the Middle East conflict may as well challenge this assumption. 

Fed officials have given a feeling that another 50-bps policy rate cut is likely to happen this year followed by a 1 percentage-point cut in 2025. However, in his post-policy interaction with the media, Fed Chairman Jerome Powell stated that this cut should not be interpreted as the new pace. It is also to keep in mind that though the inflation is currently around 2.5%, which is very nearer to the Fed’s medium-term target of 2%, one cannot expect a large reduction in the policy rates for it may lead to the risk of inflation turning sticky—which the Fed obviously won’t like. All this leaves the market with a caution: projections being projections, one has to wait and see how the Federal Open Market Committee moves forward. 

Intriguingly, the current rate cut comes despite most economic indicators of the US looking fairly solid. In such a scenario, lowering interest rates could increase consumer spending relatively quickly. Over it, Powell described the rate cut as a calibrated move to take the policy rate to the neutral rate—a policy rate that is neither restrictive nor accommodative. And, the committee expects the long-run neutral rate to be around 2.9%, while analysts place it around 3.5%, for the US budget deficit has increased considerably. So, this phenomenon may impose limitations on the scope for steep rate reduction.  

So, to that extent the current easing cycle being different, global capital flows are likely to remain constrained. Of course, India had so far managed the Fed’s tightening storm rather effectively. Now that its easing cycle is underway, it may have to manage the resulting fluctuations in capital flows in such a way that it would not cause any upward pressure on the rupee, for it could affect Indian exports. In the same vein, the Reserve Bank of India may have to stay focused on maintaining the inflation rate well within the target of 4% sustainably.

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Is Inflation Getting Entrenched?

“Inflation is taking too long to get back to target,” told Gita Gopinath, first deputy managing director of IMF to the ECB’s annual forum in Sintra, Portugal, which, according to her, warrants that “central banks, including the ECB, must remain committed to fighting inflation even if that means risking weaker growth or much more cooling in the labor market”. 

She even feared that structural factors such as redesigning global supply chains, geopolitical tensions, and climate change may further prolong inflation. Obviously, all this points to the risk of “inflation getting entrenched” and thus the scope for returning to the ultra-low interest rates that prevailed during the pre-pandemic is less likely.  

Recalling the experiences of the high inflation period of the 1970s, she, while addressing the annual conference of the Central Bank of Brazil, also cautioned that “Central banks must remain resolute in keeping policies tight and recognize that insufficient monetary tightening now may necessitate even more painful actions down the road”. 

It is needless to say here that fiscal restraint will go a long way in aiding central banks’ fight against inflation. For, in an environment where the growth outlook is uncertain and the rates of interest are likely to stay higher for longer, there is every need to observe fiscal restraint. Else, there is a danger of financial market instability.  

As against these happenings in the developed world, emerging market economies, aided by well-orchestrated monetary policies and reforms, are reported to have maintained growth in recent years. Nevertheless, owing to the tightening of monetary policies by the developed countries, emerging economies may still face “considerable downside risks” that may worsen the conditions. 

Against this global scenario, Indian consumers are continuing to struggle to cope with a sharp rise in the prices of kitchen essentials such as vegetables, rice, pulses, etc. This overall rise in prices across a wider food basket is perceived by a few analysts as a reflection of the unsettling build-up of underlying inflationary pressure in the economy.  

The retail inflation data released by the government for May reveals that prices of pulses have reached a 31-month high of 6.56%. And the stock limits imposed by the government on traders of lentils appear to have had little or no impact on their price behavior. Similarly, there is also an increase of 19% in the price of rice. Of course, there is always the element of seasonality of crop arrivals to market playing a role of its own in determining the prices of agricultural produce.   

It is in this context that the announcement of the India Meteorological Department (IMD) revealing a 23% deficit in the all-India rainfall in the month of June is causing concern. For, it has impacted the Kharif sowings:  the acreage under paddy is reported to have come down by 5.6% vis-à-vis last year’s level, while in maize and cotton, the shortfall stood at 2% and 4.6%, respectively. 

Added to it, as El Nino is in play this year, it is feared that owing to the fact of the accompanying negative Indian Ocean Dipole (IOD)—also known as the Indian Niño—conditions remaining neutral so far, there is a likelihood of a sub-par monsoon this year. If the conditions turn negative, it could cause severe drought across the country. And history is replete with instances where IMD’s long-range forecasts issued in the months of April and May turned out to be overestimates. Should this happen again, it is certain to pose upside inflation risks. 

Furthermore, given the critical impact of monsoon rains on the Indian economy, delayed arrival of the monsoon and the forecasted deficiency in rainfall is certain to pose a threat not only to prices of food products but also to the growth estimates as spatial patterns and distribution of rainfall assume utmost significance. Therefore, policymakers must keep a constant vigil on the evolving IOD conditions as commented by IMD from time to time, and be ready with appropriate policy measures to counter the drought-driven spike in food prices. 

In a nutshell, all this calls for a close monitoring of liquidity in the system and its agile and flexible management. Of course, the Reserve Bank and its monetary authorities are well seized of the matter as is revealed by their proclamation that the monetary policy shall firmly stay focussed on maintaining price stability. Equally important is the management of fiscal deficit, for that is what ultimately matters in managing the inflation-growth dynamic.

It is however worth remembering here that experiences of the past suggest that even a small amount of sticky underlying inflation makes the task of taming it more difficult!   

Inflation & India's Challenges

In its latest annual report, the Bank for International Settlements (BIS), observing that by April 2022 “three-quarters of economies were experiencing inflation above 5 percent”, warned the Central Banks that “inflation was back…as a threatening foe”. Though many have dismissed the rising inflation as a transitory phenomenon, it simply spread widely across countries raising the alarm of stagflation—a prolonged episode of weak growth along with persistently high inflation. 

Amidst this world-over concern about rising inflation, India’s headline inflation hit an eight-year high of 7.79 percent in April as against a year earlier, which however moderated to 7.04% by May. Nevertheless, it remained above the RBI’s targeted upper band of 6 percent. Reflecting on the recent surge in inflation, the Governor of RBI is reported to have said to the effect that there are “global factors in inflation.” What he perhaps meant was that Ukraine war-driven rising prices of food grains, fertilizers, and crude oil, and the strengthening US dollar are directly exerting inflationary pressure on the Indian economy. 

There is, however, a section of economists, who are vehemently arguing against the hypothesis of imported inflation, stating that it is the rising domestic food prices that are pushing Indian inflation further high. And they don’t appear to be way off the mark! For, according to the Ministry of Statistics and Programme implementation, prices of vegetables have posted a soaring year-on-year percentage change of 18.3% on May 22 followed by oils and fats:13.3%; spices:9.9%, meat and fish:8.2%; prepared meals, snacks, sweets, etc.: 7.1%; milk and milk products:5.3% and non-alcoholic beverages: 4.9%. 

They also point out that food prices are rising faster than that of other goods—their relative price is rising. Further, in support of their argument, they are also citing the fact that inflation in India was trending upwards from October 2021, i.e., well before the war in Ukraine started. Hence, they opine that in a scenario of fast-rising food prices vis-à-vis other commodities the rise in repo rate may not be an effective tool to control inflation. For, rising of interest rate being a macroeconomic instrument, can at best control economy-wide excess demand but not any particular price. 

Indeed, this kind of concern about the inadequacy of monetary policy to address the challenge posed by the food-price-driven inflation was voiced even by Joseph Stiglitz, Nobel laureate in economics. He said at Davos that “raising interest rates is not going to solve the problem of inflation. It is not going to create more food. What you do is that you have supply-side interventions. Killing the economy through raising interest rates is not going to solve the inflation in any time frame… At least, trying to do everything we can globally to increase the supply is going to do more in dealing with the problem.”

Even the Fed Chairman, Jerome Powell in his presentation to the US House of Representatives in June, admitted that “a big part of inflation won’t be affected by our tools”, though it is committed to control inflation unreservedly. All this clearly shows that there is very little that the RBI can do to arrest rising energy and food prices.

Over it, in a regime of high inflation, big shifts in relative prices spread across the economy much faster. In such a scenario, expectations become crucial. When people expect prices to go up, they would become more defensive. This in turn may set in motion the danger of a wage-price spiral. Further, as BIS states that any attempt to wish away the price rise as more due to “exogenous” supply shocks will do more harm to an economy than good. For, what is exogenous to one economy often tends to become endogenous to all the economies.

Intriguingly, RBI’s act of rising interest rates has a side-effect too: it adversely impacts growth in the economy. And, persistent high inflation and falling growth are likely to land the country in recession.

No doubt these hard realities, coupled with the unrelenting array of global supply shocks, are making policy calibration a true challenge. For, there are too many dilemmas—compressing external imbalances, preserving macro stability in a hostile global environment by compressing fiscal deficit, addressing the excess demand in the market for foodstuff, etc— to be resolved, that too, without sacrificing growth. A big challenge! Nevertheless, it is necessary to progressively bring inflation down towards its medium-term target in such a way that it hurts growth minimally.

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Rupee: A Storm in the Offing?

 

The US Federal Reserve’s aggressive campaign against inflation—hiking interest rates by 75 bps to 1.75%, the biggest increase since 1994—has boosted the dollar. Over it, the Fed has also cut its outlook for 2022’s economic growth: now predicting a 1.7% gain in GDP as against the 2.8% forecast in March. When a country raises its interest rates, the yield on debt issued in its currency obviously rises as well—a key factor behind the current surge in the dollar value. 

Coupled with the fear of recession spreading across the currency markets, the dollar has simply soared. As a result, the US dollar index—a measure of the value of the dollar against a basket of six foreign currencies, namely, the euro, Swiss franc, Japanese yen, Canadian dollar, British pound, and Swedish krona—has recently surpassed its 20-year high and is currently trading at over 106. 

This, coupled with the continuous rise in natural gas prices as a sequel to the ongoing Russia-Ukraine war, and the traders’ worry over the European Central Bank’s weakened effort to fight inflation, led to the fall of the euro by 1.7% to $1.03, its weakest level against the dollar since 2002. 

In sync with these global developments, as FIIs, seeking the safety of dollar-backed securities, unwind their investments in the Indian stock market, the rupee is fast losing its value: it plunged to its lifetime low of 79.28 to the US dollar on July 6.  Traders opine that had the Reserve Bank of India (RBI) not intervened timely by way of selling dollars in the form of derivatives and spot market interventions, the pace and intensity of depreciation could have been still worse. Yet, many analysts and traders expect the rupee to depreciate further to ₹82 a dollar in the coming months.

Of course, it is not the rupee alone that faced this reversal, several other Asian currencies, including the Chinese yuan, fared even worse.  But India has much to worry about, for the rupee has been declining steadily all through the year, losing as much as 6% against the dollar in 2022. And there is also a belief in the market that India’s forex reserves have depleted by more than $50 bn—dropped to below $600 bn from an all-time high of $642 bn—owing to the RBI’s market intervention operations to support the rupee, while officially it is explained as a consequence of the drop in the dollar value of assets held by the central bank. 

That aside, according to the estimates of the Ministry of Commerce and Industry, India’s merchandise trade deficit hit a fresh high of $25.6 bn in June, that too, in a row for the second month. Indeed, our international trade is facing a double whammy: on one hand, exports are sliding and on the other imports have surged by over 51% to $63.6 bn in June, more owing to the rise in global oil prices. As imports are crossing the $60 bn mark continuously for the last four months and the weakening rupee is all set to raise import costs further, there appears to be no scope for exports to rise in the foreseeable future as the growth in developed markets is expected to slow down drastically. So, it will not be surprising if the current account deficit, as expected by analysts, touches a ten-year high of 3.3% of GDP in the current financial year. All this, coupled with high domestic inflation is certain to hit rupee further down, challenging the wit of policymakers. 

In the wake of these adversities, the RBI has announced a slew of temporary measures—incremental NRE, FCNR(B) deposits exempted from CRR/SLR till November 4, allowed banks to raise NRE, FCNR(B) deposits without reference to regulations on interest rates, FPI investment norms regarding government bonds relaxed for new issuances of 7-year and 14-year maturity making them eligible for the fully accessible route, norms eased on residual maturity for FPI investments in government and corporate debt, limit under the automatic route for ECB increased to $1.5 bn along with a rise in the all-in cost by 100 bps— to augment forex inflows to protect the sliding rupee amidst the depleting forex reserves and also perhaps, to offset higher imported inflation. 

Now, the question is: Will they work in today’s integrated global financial market? There is no ‘the answer’ for, amidst the ongoing war between Russia and Ukraine, soaring oil prices, the looming threat of global recession, and more particularly, as most of the central banks are moving towards aggressive tightening of monetary policy nothing can be said for certain, except to wait and watch.  

President Joe Biden Re-nominates Jerome Powel as Fed Chair

One of the most critical decisions that President Joe Biden took in the recent past was re-nominating Jerome Hayden Powell as Chair of Fed on November 22, 2021 and nominating Dr Lael Brainard as Vice Chair of the Board of Governors of the Federal Reserve System, hoping that the leadership of these two will deliver: one, “focus on keeping inflation low, prices stable and delivering full employment”, and two, by addressing the “economic risks posed by climate change” and staying “ahead of economic risks in our financial system”, will make the US economy “stronger than ever before”.

Much against the wish of the left wing of his party, and ignoring the equally strong candidature of Lael Brainard, by nominating a Republican and a former private equity lawyer whom former President Trump had elevated for the first time to the Fed’s Chair, President Biden not only established his own independence but also kept alive the bipartisan approach that has been practised in the recent decades to fill the position of Fed Chair.

Over it, “for the first time in 30 years inflation has become the salient political issue”, in the US. On one hand the team ‘transitory’ asserting that it is the pandemic-induced bottlenecks that disrupted supplies leading to price rise, argue that the current price rise is a transitory phenomenon and needs no action. They are even arguing that a small rise in prices is indeed beneficial, for inflation expectations were too low during pre-pandemic period.

As against this, the ‘permanent’ block argues that temporary bottlenecks are not the only forces that are pushing prices. They fear that persistence of inflation is likely to emerge from sharp rise in spending that is mostly resulted from the very large fiscal stimulus launched to fight the pandemic blues. According to them, monetary authorities have failed to temper this demand. There is thus a common feeling among certain economists that Powell is not proactive enough in the fight against inflation.

Joseph Stiglitz, commented in a column that Powell “supported former President Donald Trump’s deregulatory agenda, risking the world’s financial health”. A similar feeling is expressed even by some of the democrats: he is “too soft as a bank regulator.” Stiglitz also observed that Powell is “reluctant to address climate risk though other central bankers around the world are declaring it the defining issue of the coming decades”. He wonders that Powell might say “that climate issues are not included in the Fed’s mandate” which in his opinion is wrong because, there is no greater threat to financial stability than climate change.

As a member of the Fed Board of Governors, Powell, according to Stiglitz, “has a history of misjudgements in tightening monetary policy dating back to the ‘taper tantrum’ of 2013”.  There is yet another criticism that came up recently against the Fed: ethics scandal involving market trades during the pandemic made by top Fed officials that benefited them financially. Perhaps, taking all these aspects into consideration, Stiglitz opines that the US “needs a Fed that is genuinely committed to ensuring a stable, fair, efficient and competitive financial sector”.

Indeed, he subtly favours Lael Brainard, who “has already shown her mettle” while being on the board already. Incidentally, Kenneth Rogoff, former Chief Economist of IMF, while opining that Lael Brainard might have proved to be an excellent choice, observed that she still would have “required a period of adjustment for markets to understand her language and signals” whereas re-nomination of Powell made Fed policy more predictable and easier to interpret” for the markets, more so in the post-pandemic economic scenario, where the economy is “still incredibly volatile.”

Over and above all these arguments, one factor must be borne in mind: Chairman of the Federal Reserve of the US, the world’s largest economy and de facto reserve currency, is a very important position. For, Fed Chairman enjoys a greater say in the realm of economic policy. The Chair could even assert enormous influence on the behaviour of economy by timing interest rate cuts in such a way that it favours the sitting President in the elections.

Amidst such a scenario, re-nomination of Powel as Chairman calls for political gumption and that’s what President Biden, unlike his predecessor, exhbited to ensure the independence of the Fed. And this in turn ensured that the US has a seasoned hand at Fed to steer the economy through the post-pandemic recovery.                                                

Simultaneously, Biden, being a seasoned politician, calling Lael Brainard “one of the country’s most qualified and dedicated public servants” who is committed to “getting inflation down…”, nominated her to Fed as Vice Chair. This move shall simultaneously take care of the anxiety of a section of the Democrats about Powell being “too soft as a bank regulator”, for Brainard is a known stricter on the banking industry.

With this duo at the helm of affairs, let us hope that America’s economy will be “able to recover from a once-in-a-generation health and economic crisis”, which in turn shall pave the way for global economy to rebound from the ills of the Covid-19. 

RBI’s Interim Dividend to Government: Any Surprise!

It is reported that the Board of directors of Reserve Bank of India   “based on a limited audit review and after applying the extant economic capital framework”, had decided to transfer an interim surplus of Rs 280 bn to the central government for the half year ended December 31, 2018.  This highly anticipated and generous move of the RBI will take the total transfer of funds from the RBI to the government in fiscal 2019 to Rs 68,000 cr, which is substantially higher than the Rs 50,000 cr transferred during the fiscal 2017.

Incidentally, it is the second successive year in which RBI will be transferring an interim surplus to the government as against the usual practice of transferring the profits after the closure of its financial year (July-June) and submission of the Board approved statutory annual report to the government in August.

However, this transfer of an interim dividend per se is not a great event except that it is crucial for the government to meet its revised fiscal deficit target of 3.4% for the fiscal 2019, more so in the light of its lower than expected revenue collection via the Goods and Services Tax (GST) channel, the increased demand for recapitalization from the public sector banks and the increased budgetary allocations under social welfare schemes. Intriguingly, this transfer also sends a clear signal that this time round, the government is not as aggressive in pushing RBI to transfer a huge chunk of reserves as it had been in its argument for the reserves earlier. 

Nevertheless, payment of interim dividend by RBI has become a hotly contested issue in the recent past. For, as the reports go, ever since Arvind Subramanian, the former Chief Economic Adviser to the government argued that the RBI is sitting on a pile of reserves that could be put to more productive use if only they are transferred to the government, the central government had been putting pressure on the RBI to transfer more funds from its contingency reserves to exchequer stating that it is holding more than what most central banks across the world hold in relation to their assets. Extending the argument further, the government, saying that the RBI holds about 27% of its assets as capital and reserves as against 13-14% held by most of the central banks around the world, indeed suggested for transferring about Rs 500,000 cr to the government .

Evidently, it is simply a fiscal drive of the government, but it would result in a sea change in the RBI policy framework pertaining to maintenance of reserves and the autonomy that it enjoys in its maintenance. It is in this context that the erstwhile governor of the RBI, Urjit Patel—who argued that the reserves it accumulated over the years through interest income and seigniorage should be left with it as contingency funds to ensure financial stability in the economy—was suspected to have engaged in a bitter face-off with the government that is eager to gain access to RBI’s reserves, and finally resigned, of course, citing personal reasons.

But the fact remains that an economy which is in transition like that of ours is more vulnerable to external financial shocks under which RBI should not stand exposed as though lacking necessary reserves to defend the rupee and hence needs higher reserves vis-à-vis the central banks of the western world. It is in order here to recall what the YH Malegam committee of 2013 recommended: each year RBI to transfer 15% of the original cost of fixed assets to the prevailing asset development reserve. As against this, reports indicate that in the previous three financial years ending fiscal 2017, RBI did not transfer any funds to its reserves but transferred the entire profit to the government. Raghuram Rajan, former RBI governor, opined that reduction in the assets of RBI will reduce its ability to absorb government borrowings by buying bonds. It is in this context that many have questioned the recent RBI’s generous payment of interim dividend. The matter is thus complex, calling for rejigging the economic capital framework of RBI urgently.

Let us hope that the panel formed to review the economic capital framework headed by Bimal Jalan, former RBI governor, will come up with a rational document that puts all these controversies to rest by determining the adequate level of reserves by assessing its risk-buffer requirements in a systematic manner and indicating the capital that the Central Bank needs to hold to perform its role of managing macroeconomic stability effectively.

Central Banks and Independence: Myth and Reality

The significance of the Central Bank’s independence once again came into the limelight when the RBI’s Deputy Governor, Viral Acharya, concluded his A D Shroff Memorial Lecture in a fiery voice cautioning that “Governments that do not respect Central Bank independence will sooner or later incur the wrath of financial markets, ignite economic fire, and come to rue the day they undermined an important regulatory institution.” On the other hand, governments that “invest in Central Bank independence”, according to him, “will enjoy lower costs of borrowing, the love of international investors, and longer lifespans.”

Conceptually, there is evidence to the effect that the Central Bank’s independence benefits a nation with price stability. For, literature reveals that decision makers who are subjected to election-cycles tend to act more in a short-sighted manner for they have an obligation to deliver their proclaimed manifestos, that too, with the accompanying element of ‘immediacy’. But such short-termism often turns out to be inflation-biased. As against this embedded weakness of elected leadership, a Central Bank, having longer horizons of decision making vis-à-vis elected governments, can afford to factor in medium to long-term consequences into its decision making and thereby could stabilize the economy over business and financial cycles. 

When we talk about independence of Central Bank, what we essentially mean here is: the Central Bank must be given a limited and clearly defined mandate for achieving the assigned inflation target.  For, such a clear and limited mandate alone enables the Parliament and the public to monitor and evaluate the performance of the Central Bank. Secondly, such well-defined mandate also helps avoid overburdening of Central Bank.  Incidentally, with the appointment of Monetary Policy Committee (MPC) two years back, Reserve Bank of India [our Central Bank] is made solely responsible for managing the inflation rate in the country within the mandated range.  And, by formalising this arrangement through appropriate enactments, government has strengthened the independence of the RBI. 

That said, it must also be admitted here that independence of Central Bank does not mean isolation from the democratically elected institutions, which is why there should always be a dialogue between the Central Bank and the government. But before getting into the nitty-gritty of such a dialogue, let us first look at the discordant elements that have crept in, in the recent past, between the two. As cited by Acharya in the said lecture, the first one is: RBI’s demand for making the regulatory powers of public sector banks ownership-neutral. In short, what it calls for is: that “the government should acknowledge full operational authority and independence in supervision and regulation” of banks by the RBI, as it did in the case of monetary policy.  The second one is the row over the RBI’s burgeoning reserves, a part of which the government is eyeing for bridging its fiscal gap, which the RBI is resenting heartily. And the third one is: the proposed appointment of an independent payments regulator by the government, which the RBI perceives as an encroachment on its turf. 

In the same vein, the government too is having certain grouses against the RBI. One, it argues that having allowed regulatory forbearance on NPAs of banks for quite long, imposing stringent rules now—rules that are more rigorous than even international norms—for identification of quality assets particularly, its doing away with all restructuring schemes and asking banks to make higher provisions, is adversely impacting credit growth. Similarly, it also questioned the wisdom of the RBI in placing some PSBs under prompt corrective action, for it could lead to liquidity crisis, which, in its view might threaten inclusive growth.

Thus, there are questions emanating from both sides which need to be answered. But what is to be appreciated here by the warring parties is: that there are no readymade answers for them. Of course, it does not mean they are insurmountable. All that they call for is: a constructive dialogue between the regulator and the government to understand each other’s perspective and to draw a workable template, the ultimate execution of which shall ensure stability in the markets. And importantly, it is to be noted that any adverse comment by the government is potential enough to undermine the confidence of market players in RBI.  

Here, it is also necessary to appreciate the fact that in a democratic setup, no one is independent, for in the ecosystem, everyone is ultimately accountable to someone or the other. And it is equally necessary to appreciate that ‘independence’ is not something that is ‘given’; rather, it reflects more in one’s action. Incidentally, we have been witnessing such actions all through from the RBI. For instance, even well before the establishment of Monetary Policy Committee, there are occasions in the past when RBI remained un-influenced by the government’s desire for lowering interest rates so as to stimulate growth in economy. And another important point here is that one must “not to confuse independence” as Mark Carney, governor, Bank of England said, “with omnipotence.” 

That being the reality, the RBI—for instance, as the government commented recently in the context of the fraud in PNB—should have asserted itself in supervising banks and bringing out the fault lines to the notice of the owner, the government. For, it has regulatory powers, under the Banking Regulation Act, 1949—which are indeed vast in scope—to regulate banks’ lending activities through physical inspection of banks and their financial audit from time to time and also through its nominee directors in the boards of Public Sector Banks. 

In the same vein, the government should have articulated its political needs with the RBI and sought a way forward to pursue them without, of course, derailing the economy. Instead if they clamour for independence or ride over the other, that too, from public forums, they would only be doing injustice to the economy, for all such acts are sure to set markets on fire, or to borrow Acharya’s words, they are sure to “ignite economic fire.” It is of course, for them to either set the economy on fire or douse the fire, “But will they?” — no, it’s not a lament but a timely challenge to them.

Rupee Drops to a Fresh Low: Challenges Ahead

As August inched towards its end, rupee, opening at 70.69 as against the previous day’s record closing rate of 70.59, fell by 0.21%, and what was more disturbing was: going forward the trend appears to be weak.  And the reasons for such a steep fall are not far off: the heavy month-end demand for dollars from importers, particularly from oil-importers and foreign capital outflows from the capital market, plunged rupee to an all-time low. It all started with the political turmoil in Turkey which impacted its lira vis-à-vis dollar and the contagion spreading to all other emerging market currencies. But it is the rupee that has become the worst performing currency in Asia, depreciating almost by 9% since January. It is our widening current account deficit, which is around 2.5% of GDP for FY 19 that caused continuous shortage of dollar liquidity which is primarily responsible for this fall. 

Of course, the Reserve Bank of India (RBI) has been intervening in the currency market to slowdown the fall of rupee, and in the process, its reserves have indeed come down from an all-time high of $426.88 bn in April 2018 to $400.8 bn for the week ended 17 August. Yet, some dealers opine that its intervention is not matching the kind of rising demand for dollars that the market is witnessing.

As the RBI pointed out, in the days to come, rupee is likely to be impacted by global risk factors such as: one, geopolitical developments in West Asia leading to sharp hike in crude oil prices; two, faster-than-anticipated pace of rate hike by the US Fed; and three, trade-related tensions across the major trading partners such as the US, Eurozone, China, etc., and the resulting volatility in the financial markets. 

That aside, even domestic factors such as the growing cost of the rising import of crude oil owing to rising global prices, lowering of goods and services (GST) rates on a range of consumer goods, the tax cut on small businesses and the relatively high minimum support prices declared by the government for agricultural produce are equally causing concern, for cumulatively they are certain to adversely impact the fiscal position. And, increased fiscal deficit is likely to fuel the inflation further, which in turn will have its own impact on exchange rates.

Here it is in order to recall what Raghuram Rajan, Professor from Chicago University, said at this year’s Jackson Hole get-together of Central bankers. He said that risk is building up again in the system and the trade-wars initiated by the US are potential enough to trigger the vulnerability in the system into a crisis. And, the prevailing global and domestic risk factors that India is facing are likely to expose us to such vulnerabilities.  

As commonsense would dictate, it is the importers who are very displeased with the falling rupee, for it straightaway affects their profitability. But surprisingly, this time round, even exporters are vociferously airing their concern against the depreciating rupee. They lament that in the wake of continuously falling rupee, they are finding it extremely difficult to negotiate a right price with their importers. However, at the same time, citing REER, they also argue that any depreciation of rupee is a move in the right direction, for it makes rupee more competitive among the trading partners. And this, they argue, shall in turn give boost to our exports. But this appears to be a myth, for our exports have indeed grown when the REER has grown. That aside, what exporters need to bear in mind is the impact of domestic inflation likely to be caused by depreciating rupee on the costs of their exports.  

Now, this raises an obvious question: Should the policy makers let the rupee spiral down in this manner? There is no ‘the’ answer, but the prevailing global factors warn us not to fall into the trap of exporters’ arguments. Even otherwise, the REER announced by BIS Board places rupee at 100.39, which means there is no overvaluation of rupee, while the REER of RBI calculated with 2004-05 as the base year against the currencies of China, Hong Kong, the US, Eurozone, Japan and UK currently stood at 123—meaning rupee is overvalued by 23% in relation to these economies. This difference in the estimates of BIS and our RBI demands a fresh debate on the very style of calculation of REER by the RBI.

That being the reality, the way forward is: improving our macroeconomic fundamentals and diversifying our exports. This obviously calls for requisite structural reforms on the lines that the RBI has recently asked for. Introducing short-term measures such as allowing manufacturing firms to avail external commercial borrowing of up to $50 million for one year maturities in place of the existing three-years is certainly a bad idea. For, such measures can only help us tide over the immediate crisis but are sure to create more stress in the future as the short term external debt is already hovering around 42 percent of the total foreign currency loans. Yes, imposing import curbs on non-essential goods is likely to ease to current account deficit. Similarly, government not yielding to the demand for cutting duties on petrol and diesel is in the right direction, for it can reduce demand (?) and certainly pave the way for environmental improvement. And revisiting some of the measures that RBI took in 2013—opening a special swap-window for oil importers and even inviting FCNR deposits with attractive interest rates—is no bad idea at this juncture.

So, in the ultimate analysis, the focus of the policy makers should be on long-term reforms that can improve our current account deficit. And that is what the policy makers should address fast if we wished to stop depreciation of rupee on a long-term basis.