Travelling through Europe and England this week, we have encountered a view from some investors that there is a trade-off between FX stability and economic growth, and the RBI, under the newly appointed governor Rajan, needs to follow up its July tightening measures by even more rate hikes to support the rupee. This would inevitably entail further "sacrifice" of growth, as per the view.
The view has been bolstered by governor Rajan's inaugural statement, where he stressed the importance of low and stable inflation, regardless of its source (FX pass-through, demand pressure, supply shock). But beyond the discussion on price stability, the rest of the governor's statement was geared toward lowering the cost of doing business. Indeed, we think that RBI is done with tightening for now.
Let's examine the inflation question first: with faltering growth and worsening employment and wage outlook, inflation is clearly not being driven by demand, so the case for easing price or wage expectations through tightening is not relevant at this juncture. The risk to inflation is presently coming from INR depreciation and higher global oil prices. We don't think even weaker demand would negate pass-through risk or supply shocks; indeed in recent years demand fluctuations have not correlated well with WPI/CPI price dynamics.
Can higher rates attract bond and stock market flows? There are very few carry opportunities for foreign fixed income investors, so higher rates won't attract inflows the way it tends to be the case in more open economies. Higher rates could bring in NRI flows, but that can be accomplished by deploying narrow instruments like raising the FCNR deposit ceiling as opposed to a broad-based tightening of liquidity and spike of short term rates.
In any case, the authorities are seeking to attract stickier FDI than volatile portfolio flows, which won't be helped by higher rates and associated correction in demand and clouding of the outlook. Higher rates and ensuing slowdown won't surely help foreign equity investors, whose holdings are far larger than bond investors in India.
Finally, higher rates were supposedly aimed at curbing speculation and FX volatility. On the former, we don't know of any major channels through which widespread rupee speculation was taking place right before July 15. Indeed, FX volume had collapsed due to the various restrictions placed on futures and options market activity and curbs on trade-related FX engineering. Additionally, the fact that banks continue to access liquidity at high cost even today means that genuine transaction need, not cheaply financed FX speculation, was behind the persistently large demand seen in the LAF window prior to July 15. On the latter, the evidence shows the measure had the opposite effect. FX volatility has been higher since July 15, and currency's slide accelerated after the liquidity tightening measures were implemented.
Can India afford higher rates? Corporate and banking distress is spreading, consumer sentiment and consumption indicators are waning, and businesses are reeling from a 20% rise in the cost of imports and several hundred basis points of rise in financing costs. With growth heading toward 4%, higher rates could risk severe balance-sheet stress and cause further economic volatility and slowdown.
This is not to say that fiscal adjustment or import compression measures should be withdrawn. Those steps need to continue as current account adjustment is essential. But monetary policy should not inject further negative impulse for the reasons stated above.
As hinted in governor Rajan's inaugural statement, we expect RBI to start looking hard at stabilizing the financial system (securing financing through swaps etc, for example) and communicate that at this juncture inflation will not be assigned exceedingly high weight in its reaction function. In case we are wrong and the RBI comes out with a hawkish guidance on Sept 20, we will revise down India's growth forecast further.
Source:Economic Times
