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India’s Macro Policy Jugalbandi Picks Up Tempo

RBI is suggesting that it is willing to take the short-term risk of carry trades at the cost of securing some short-term flows.

<div class="paragraphs"><p>Finance Minister Nirmala Sitharaman and RBI Governor Shaktikanta Das, attend the RBI's central board meeting, in New Delhi, on July 8, 2019. (Photo: Reuters/Anushree Fadnavis)</p></div>
Finance Minister Nirmala Sitharaman and RBI Governor Shaktikanta Das, attend the RBI's central board meeting, in New Delhi, on July 8, 2019. (Photo: Reuters/Anushree Fadnavis)

India has a short-term macroeconomic situation. High oil prices—India’s bug-bear given our large dependence on oil imports—have meant that the current account deficit has widened. At the same time, a slowdown in flows into private equity and venture capital and the continued outflows by portfolio investors have left the capital account in deficit. This has meant that the Reserve Bank of India has had to sell its foreign exchange reserves to a) bridge the capital deficit and b) protect the Indian Rupee from depreciating sharply.

The fact that the RBI has had to announce measures to liberalise foreign exchange inflows should tell us that they expect the situation to worsen and/or remain concerning enough to need short-term inflows so as to not give up more of its foreign exchange reserves. It also indicates that in the quest to stem the depreciation, they may have sold more than the desired forex reserves. The reality that the rupee has performed better (read depreciated lesser) may for most parts be due to the aggressive intervention by the RBI.

However, before we look at what they have announced and its impact, it is important to understand the steps, the rationale and the macro-approach being used. The economy is managed by two agents: the Ministry of Finance and the RBI.

Since the start of the year, we have seen both these agents actively trying to manage the impact of a global commodity price shock, the impact of the Russia-Ukraine conflict and the hawkish global monetary policy environment.

Contrary to common beliefs, it is the Finance Ministry which has more tools to fight inflation.

The RBI has levers it can use to manage the currency and boost foreign exchange inflows. However, it requires close coordination and both the economic agents need to be in sync. It was the RBI which began normalising its excess liquidity and then shifted its priority from boosting growth to managing inflation. They stepped up the pace of rate hikes (135 basis points since April 2022) as a signal of its changing stance. Despite this, the repo rate remains well below its long-term average while consumer price inflation is above average.

No one really believes that the RBI can get short-term supply-side inflation under control through rate hikes. By hiking rates and tightening liquidity, RBI is only trying to manage expectations by showing its clear intent.

The Finance Ministry then did its bit to cool domestic inflation. It levied a tax on steel exports. It cut import duties on edible oils. It increased the subsidy on food and fertiliser to buffer the price impact. The government cut its revenues accruing from oil prices by lowering the sale price. We recently saw ‘windfall’ taxes on oil exports and production, again as a means to either reduce domestic prices or shore up revenues to provide some more subsidies to consumers. The Finance Ministry then tinkered with gold import duties in the hope to reduce imports but it knows the impact would be limited.

It is thus back to the RBI. The central bank knows the buttons to push and the levers to pull to augment short-term capital flows. Given that most measures announced are time-bound till October or December 2022, it suggests that the RBI wants to attract flows and wants that to happen in the next 3-6 months.

Why These Moves?

One should wonder and question why. Does the RBI fear a large depreciation? Is it touchy about the Dollar/Rupee reaching 80? Why can’t the RBI allow the rupee to depreciate and hope for a natural macro adjustment?

Although these measures announced are not like the ones used in 2013, by tapping the proverbial ‘non-resident Indian’ flows, some may feel that the RBI is under pressure.

It is the NRI who has almost always bailed out India’s external account, be it in 1998 or 2003 or 2013. Liberalising NRI deposit flows, seemingly so early in the cycle, would raise some heckles.

However, it is also a sure-fire route to augment flows. By providing a higher interest rate and also allowing the banks some incentives to do so (cash reserve ratio / statutory liquidity ratio relaxed), we should expect NRI deposit flows to increase. Banks will create ‘hedged’ dollar return structures which will make the Indian deposit much more attractive than what is available to savers in their foreign locations.

We would caution, though, that this is not the FCNR deposit swap that was offered in 2013. That scheme had an explicit subsidy to guarantee a dollar return. Also, it allowed banks to provide leveraged deposits. Today, with the market cost of funding and hedging, the returns on offer are not that attractive. Also, banks already have excess liquidity. We will get some flows, but it won’t be large.

Ideally, the other move on allowing foreign portfolio inflows into short-term debt instruments should have also been enthusing as well. However, over the last 3-4 years, India has almost gone off the radar of the emerging market local currency bond investor. We have seen continued net outflows and hence we remain unsure of the extent of such flows.

We could see some fixed maturity plan-like structures that can offer leveraged, hedged dollar returns to the global investor for a 6-month to 1-year segment. Those would also face the same hurdle of the required dollar return being much higher than what is on offer globally.

There is a reason India does not allow such ‘carry’ flows into its bond market. However, by allowing it now, RBI is suggesting that it is willing to take the short-term risk of carry trades at the cost of securing some short-term flows to boost the supply of dollars in the currency market.

The other way to look at it is that by announcing it now, it is ensuring that speculative attacks on the currency may be prevented for the time being. These measures will give RBI some breathing space to manage the rupee depreciation and its volatility.

Opinion
Will RBI's Intervention Stem The Rupee's Fall, Dollar Shortages?

What Next?

The turn will move back to the government. Apart from managing inflation, it also needs to find an external demand source for the government’s borrowing in the longer end of the bond market. I won’t be surprised if the government is looking to raise external resources through a ‘masala’ sovereign bond issuance. As I have mentioned before, the sovereign green bond should ideally be raised in overseas markets. Investors seeking green bonds overseas have a large appetite to invest.

For now, despite the macro headwinds, it seems that the Finance Ministry and the RBI are complementing and supplementing each other. However, as the situation unfolds and in music parlance, reaches a crescendo, we need to see whether the macro jugalbandi remains in tune.

Arvind Chari is the Chief Investment Officer at Quantum Advisors.

The views expressed here are those of the author, and do not necessarily represent the views of BQ Prime or its editorial team.