Does India need sovereign bonds?

Financial Express, 24th July 2013

RBI's defence of the rupee and statements of govt officials suggest the rupee has become too weak. instead of deluding themselves, policymakers might do better listening to what the rupee is telling them

In recent months, when government officials suggested that the Indian economy was still strong, most of us thought they were trying to talk up the economy. But RBI's moves to tighten liquidity and raise interest rates this week seem to suggest that the government really believes that economy is strong enough to absorb large shocks like the those meted out by the RBI. A careful cost benefit analysis of the actions of the past few days suggests that they may be making a very costly mistake. Sovereign borrowing would further add to this cost.

First, why has the rupee depreciated? India has a large current account deficit that needs to be financed by capital inflows. Ben Bernanke's statement suggesting that rates in the US may rise over the next few months led capital to fly out of EMs. Currencies that were being held up by capital flows witnessed sudden sharp depreciation. Along with India, other Ems with large CADs such as Brazil, Turkey, Indonesia also witnessed a sharp rise in currency volatility and significant depreciation. India's falling GDP growth, high inflation, poor investment sentiment and high current account deficit were unhealthy fundamentals to begin with. The US Fed provided the trigger.

Second, is depreciation bad for India at this point? It is bad for companies that borrowed overseas tempted by low interest rates. Those who don't have a natural hedge should either not have borrowed, or have hedged their exposure. On inflation, there may be little exchange rate pass through as the pricing power of companies in a low growth environment is limited. On the other hand, depreciation is good for export competitiveness and import substitution. Depreciation in a slowing economy can provide a demand stimulus to the economy. (Among the first signs already visible are tourists preferring domestic locations to foreign holidays.)

Third, even if depreciation is not good for the economy, can it be prevented? For a short while and at a very high cost, yes. Remember the basic principles of the impossible trinity: You cannot have a pegged exchange rate, an open capital account and an independent monetary policy at the same time. So we can give up monetary policy independence to peg the rate. We saw RBI do that with its interest rate defence. It raised rates despite having convinced us that despite the high inflation, the low growth in the economy had led it to lower its inflation forecasts, and the time for easing monetary policy had come.

So, yes, the rupee can be defended and it comes at the cost of raising rates at a time when the economy can least afford it. But with the tightening, the already poor sentiment about the economy, will fall further. RBI has argued that it raised rates not to attract capital inflows, but to kill speculation. So was the rise in interest rates,such as the call money rate going above its corridor to 9%, merely an unwanted and unexpected side effect? If so, it speaks volumes about the competence at RBI. And if not, it suggests that RBI is engaging in doublespeak where it is tightening liquidity that leads to higher rates,while suggesting that it is not tightening monetary policy as the repo rate has not been changed.

Fourth, are there any quick-fixes available? While the rupee may go up, the fundamental problems of the economy that have lowered productivity growth remain unaddressed. In the long run, if productivity growth in an economy is weak, it should be expected that its currency will depreciate. So, even if RBI is able to prevent further rupee depreciation for a while, unless the government addresses issues of infrastructure, land, labour, access to finance and the innumerable hurdles to investment and productivity growth in the economy, the rupee will continue to weaken in the long run.

RBI's defence of the rupee and the statements of various government officials suggest that the rupee has become too weak, that the fundamentals of the Indian economy are stronger than what the currency market is suggesting and the rupee should in fact be stronger. In other words, they believe that the market is wrong in thinking that there are fundamental weaknesses in the Indian economy. Instead of deluding themselves, policy makers might do better listening to what the rupee is telling them.