RBI Stuck Between Balancing Conflicting Objectives, Says JPMorgan’s Jahangir Aziz

Widening twin deficits will put pressure on rates and the rupee, says JPMorgan’s Jehangir Aziz.

A tightrope walker balances on a line at Malvarrosa beach in Valencia, Spain. (Photographer: Angel Navarrete/Bloomberg)
A tightrope walker balances on a line at Malvarrosa beach in Valencia, Spain. (Photographer: Angel Navarrete/Bloomberg)

The Reserve Bank of India’s multiple objectives of inflation targeting, being the government’s debt manager, and maintaining financial stability, are once again coming into conflict, making it tough to understand policy direction in India. That’s the view coming from Jahangir Aziz, head of emerging market economics at JPMorgan.

Aziz, a long-time India watcher, says that in normal times the RBI’s multiple objectives can co-exist but they tend to come into conflict every now and then. The current juncture is one such point.

“Right now it is very difficult to figure out what the RBI is targeting. Is it targeting the inflation rate? Is it targeting the 10-year (bond yield) rate? Or is it targeting financial stability by making sure that the capital of public sector banks remains preserved by giving forbearance?” said Aziz in an interview with BloombergQuint.

Under the new monetary policy framework, the RBI is a flexible inflation targeting central bank with an inflation target of 4(+/-2) percent. It, however, still retains the task of managing the government’s borrowings despite past suggestions to set up an independent debt management office. It also continues to be the banking regulator. Former governor D. Subbarao, among others, have termed this the “new trilemma”. With the trilemma remaining unresolved, the RBI once again finds itself stuck in the middle, said Aziz.

I am looking at the monetary policy, I am looking at the MPC minutes, the RBI’s actions as a debt manager, and what they are doing on the regulatory front. And it is very difficult to figure out what is it, at this point in time, that the monetary policy is targeting.
Jahangir Aziz, Head - Emerging Market Economics, JPMorgan

The Return Of The Twin-Deficits

The Indian economy, too, is facing the return of a problem from the past — the twin deficits. Aziz expects both the fiscal deficit and the current account deficit to widen in the current year. This, in turn, would lead to higher rates and a weaker currency, he cautions.

India’s general government fiscal deficit (which includes central and state government deficits) is expected to breach the 7 percent mark this year and could rise closer to 8 percent, in Aziz’s view. “It could be closer to 8 percent than 7 percent this year, given what is happening in the states, the centre and let’s add to it the fact that this is an election year,” he said.

Earlier this week, Fitch Ratings said that it expects the general government deficit to hit 7.1 percent of GDP.

Aziz also expects the current account deficit to widen considerably and move closer to 2.5-3 percent of GDP. This, he says, is not just a consequence of higher oil prices but a fundamental shortfall in savings compared to the country’s investment needs.

There are two basic drivers of Indian macro economics right now. Fundamentally, the fiscal deficit is widening and the current account deficit is widening. And the current account deficit is widening not just because oil prices are higher but fundamentally because savings in India is falling short of investments, because the government is dis-saving much more. In such an environment, you do expect rates to be higher and the currency to be weaker. That’s essentially what India is facing.
Jahangir Aziz, Head, Emerging Market Economics, JPMorgan

Easing Restrictions On Foreign Investment In Debt

In a scenario where government borrowings remain high, against the backdrop of tightening liquidity and weak demand for bonds from domestic banks, should the RBI have been more liberal with opening up foreign investment limits in the bond markets?

Aziz believes so. Most emerging market economies, including China, have opened up their bond markets to foreigners far more than India has. “...And the sky hasn’t fallen down”, said Aziz.

In April, the RBI said it would increase the FPI limit in central government bonds from 5 percent to 6 percent over two financial years. The pace of increase in limits was slower than some in the markets had expected. Last week, the RBI eased rules for foreign investors saying that they can buy government securities of all maturities, including treasury bills. Restrictions on the maturity of securities that foreigners can buy were put in place in 2014 after the experience of the ‘taper tantrum’, when foreign investor selling in short-term debt led to pressure on the Indian rupee.

Aziz believes the restrictions on maturity served no purpose and needed to be removed.

The RBI and the government have always had this problem of conflicting two things— short-term instruments with short-term investors. If you look at the depth of the 10-year bond market, then I can be a very short-term investor even in a 10-year instrument. So restricting the duration of the instrument didn’t ever make any sense.
Jahangir Aziz, Head, Emerging Market Economics, JPMorgan

Flows Into EMs Will Continue

Easing restrictions on foreign investors may or may not draw funds back into India, given the country’s changing macroeconomic scenario, but Aziz expects flows into emerging markets broadly to remain strong.

JPMorgan sees the U.S. 10-year yield rise to 3.25 percent by year-end but does not expect the dollar to strengthen significantly. With the dollar remaining benign and the growth differential remaining in favour of emerging economies, fund flows should remain strong, said Aziz.

In an environment in which we see emerging market-developed market growth differentials favouring emerging markets, as well as the dollar remaining benign, we do expect for flows into emerging markets to remain strong. There will be episodes, as we have seen over the last two weeks, where there is increased volatility because the market is repricing. But once it goes back to the fundamental drivers, we do expect emerging market flows to continue.
Jahangir Aziz, Head, Emerging Market Economics, JPMorgan

Watch the full interview here.