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Lead Story

The perfect storm
The central bank may be getting the blame for the plummeting rupee, but it is the faulty policies of UPA-II that have pushed the country into a vicious cycle of slow growth and low capital flows....

Rajesh Padmashali

Prime Minister Manmohan Singh’s sense of escapism has hit a new high after his recent trip to Myanmar. It would help if all of us were drinking from the same fountain or, still better, smoking the same weed. That clearly is not the case and what the great man said or hoped for didn’t make any sense to us.

The depreciation of the rupee may have the media transfixed of late but, for Dr Singh, there is nothing to worry about. With supreme confidence, he said, “The fall of the rupee is taking place against the backdrop of global economic problems and the Eurozone debt crisis. This is a phenomenon which is not going to last very long.” On what does he base this deep insight? Well, according to him, “solutions will emerge at the G-20 Summit in Mexico next month”.

Bimal Jalan, former governor, Reserve Bank of IndiaSure, but why would the European Union, a member of the G-20, wait for a summit in Mexico and not extinguish the ongoing Euro blaze right away? Dr Singh’s comment only follows a long list of asinine policy speak by the UPA-II government. He might as well have shared credits with Billy Joel on his 1989 hit. Remember these words? “We didn’t start the fire; it was always burning since the world’s been turning. …No, we didn’t light it, but we tried to fight it.” 

While a few shots of tequila might help sustain the delusion, the reality is liquidity injections by central banks are not paying off anymore. India as an economy did live off cheap capital from 2001 to 2011, the dip in 2008 and 2009 notwithstanding. But now the ‘smugness’ of the India growth story is increasingly being called to question. 

Having wise men in the house is one thing and implementing their counsel is another. C Rangarajan might be heading the prime minister’s economic advisory council but a lot of that expertise has only been getting lip service. Incidentally, Rangarajan headed the Reserve Bank of India (RBI) during the foreign exchange crisis of 1991 but now his role is more that of a spokesman defending government inaction. 

Nothing seems to be going right for the Indian economy at the moment. The initial estimate for Q4FY12 GDP came in at 5.3%. That dismal number was last seen in December 2008 during the peak of the sub-prime default-induced credit crunch. Overall, GDP growth for FY12 is estimated at 6.5%, against the projected 6.9%, which itself was a major comedown from FY11’s 8.4%. This naturally means that the government’s 7.6% growth estimation for FY13 GDP could be revised down. While the stock market, as is its character, has been discounting this fall in growth, the central bank has come in for some unexpected stick for the steep depreciation in the rupee.

Back to the wall

To be fair, much of the mess that the country is in today is hardly the RBI’s making. Right now, it is fighting a multi-pronged battle of dealing with weak growth, high food inflation, a depreciating currency, slowing capital flows and high government borrowing. That is not all. It also has to maintain cordiality with an administration whose ineptness is increasing by the day. A much bigger perception battle that the RBI is fighting now has been to preserve its credibility.

This is pointed out by none other than Bimal Jalan, former  governor, RBI. He says, “While we were the first country to say that we have a flexible but managed currency, currently, nobody really knows what the exchange rate policy is.” This comment has to be seen in light of how the rupee has been oscillating in the past six months. While the rupee has trended down against the dollar since last August, there was this sharp spurt in January when the rupee rebounded to 49 after hitting a low of 54.

The perception then was that the situation had been brought under control, but the latest carnage, where the rupee hit a new low of 56.50, has raised everybody’s hackles. That is because the damage that a weak currency can wreak is much larger and immediate and the domino effect is a further weakening. Ajay Shah, professor, National Institute of Public Finance and Policy (NIPFP), says the rupee’s fall should not have come as a surprise given the current account deficit (CAD) (See: Present danger). “It is likely that in the coming year, we will have a CAD of 4% of GDP, or $80 billion a year or 1,700 crore a day,” he says. “Under these conditions, even a short hiccup in capital inflows will result in sharp rupee depreciation.”

Present danger

The current account deficit has increased nearly eight times from $9.6 billion in FY91 to $74.3 billion in FY12

That essentially is the crux of the problem, a gaping trade deficit that has been so far funded by capital flows. And given ground reality, there is little the RBI can do to rectify the situation. So, does it make any sense for the RBI to continue defending the rupee, more so as it has spent close to $25 billion with nothing much to show? Jalan  says the RBI needs a more tactical approach because exchange rate expectations tend to be self-feeding.

“Left to itself, the rupee would go to 60 and the expectation would be that it will go to 70. This plays out because the exporter holding dollars thinks, ‘why I should repatriate at 55 when it is expected to go to 60?’.” That is precisely the challenge central banks face in times of crisis: not to let a self-feeding negative cycle reinforce itself. In the pre-2008 credit crunch days, the greatest weapon that a central bank had was the element of surprise. Knowing what the central bank would do to interest rates or in the currency market would be a big guessing game. 

But that is no longer true as, after the sub-prime crisis, the liquidity spigot of all central banks has been left unattended, ignoring all consequences of moral hazard. The RBI’s futile attempt to salvage the currency has resulted in some retrograde steps, says Shah. “The central bank has asked banks to limit their position in currency exchanges to $100 million or 15% of the market (whichever is lower). The RBI’s action will make the market illiquid and increase the chances of something nutty happening to the rupee.” 

Shankar Acharya, governing board member, ICRIERJayesh Mehta, managing director and country treasurer, Bank of America, says if the RBI wants, it can control the rupee tomorrow with shotgun, short-term measures, but if the macro is not fixed, then, in the long term, we may end up in trouble. Is there, then, a danger that the depreciating rupee will further worsen the CAD?

Currency gyrations are familiar territory for Jamal Mecklai, chief executive, Mecklai Financial, who says that along with rupee depreciation, slowing global growth has an equal role to play. However, he is hopeful that falling crude prices will result in the FY13 CAD being lower by $20-25 billion compared with the overall trade deficit of $180 billion in FY12.

Shankar Acharya, governing board member, ICRIER, too, shares the optimism. “The CAD will not get worse, as the decline of the rupee after a while will help. As exports rise and Indian assets look cheaper, foreign capital could come in again unless Europe collapses and reduces the export market.” 

Many fingers, notably from the government, point to the troubles in the Eurozone as contributing to their misery, an assessment that Jalan does not agree with. He says, “Very little of what is happening to the rupee is a result of the external scenario. The situation in Greece and Spain had not changed even when the rupee was appreciating in the early part of the year.” NIPFP’s Shah agrees, “The root cause of the CAD is the fiscal deficit. If we want a lower CAD, we need a lower fiscal deficit. There is no quick fix other than improving governance.”

Take it easy policy

Much newsprint and airtime has been spent discussing the lack of coherent policy direction in the UPA-II government. But the Q4FY12 GDP number has set the cat among the pigeons (See: The final blow). Jalan believes that policy consistency has become a mockery in the present set-up. He scathingly remarks, “You make a policy, then you withdraw, then you open another window, then you close it and then something else.”

The final blow

Slipping below 6%, GDP growth in the March 2012 quarter was the worst in the past nine years

Dissecting the Q4FY12 GDP numbers will make you wince some more as you think about the repercussion. While agriculture continues to disappoint, the slowdown has spread to the services sector as well. Manufacturing as well as exports were already creaking. Telecom was doing well, but there is a new ruckus there in the form of spectrum re-farming. The worst case is that nothing might happen for the next two years and industry will hold capital and bide time, waiting for a new government to come in and deliver. 

The much-bandied term for the current state of inertia is policy paralysis. In fact, Mecklai says that while the term was invented here, the US Congress is (operationally, at least) beginning to resemble our own Parliament. “Policy paralysis — where government is more and more about acting decisively only as a last resort — seems to have become a defining element of democracy in the 21st century,” he adds. Jalan fails to see the humour and is even more livid that coalition partners in the government are having their way with all sorts of absurdities.

He remarks, “How can a 19-MP party determine what a Parliament of 544 will do? The power of small parties in what the coal ministry would do, what the telecom ministry should do etc, has reached ridiculous proportions. Leadership is about credibility and doing something that needs to be done, even if it is unpopular.”

That thought, sadly, seems to have bypassed Dr Singh. In fact, his dithering makes the late PV Narasimha Rao look good. For the seasoned Rao, indecision was also a decision. Dr Singh’s hesitancy, unfortunately, reeks only of self preservation. Nothing really prevented him from taking a principled stand on what is happening around him — as an economist and a statesman, he should have put his foot down on whimsical policy reversals.

As things stand, it will be a near-impossible feat for UPA-II to make it to UPA-III. That’s a possibility the Grand Old Party might itself be resigned to and that is why it is treating its current and potential allies with kid gloves. The collateral damage of that inaction, though, is slowing domestic growth and an increasingly alienated investor community. But why is corporate India not being vehement about the issues that it is facing? For once, Jalan lets his guard down, “Corporates are not protesting in unison because they need to go to the same fellows in case they need land, ore or if they need imports clearance… and I was one of those fellows earlier.”

Giving it all

The recovery in the rupee post the 2008 crisis was driven by the expectation that things would move with the re-election of the UPA government, but now there is intense investor disenchantment. More than the rupee depreciation, what needs to be addressed immediately is the loss of confidence in the Indian economy. That onus again falls on the RBI, given the government’s lack of will to reform subsidies or impose spending curbs on various ministries. There was some token announcement of a 10% cut in non-plan expenditure, but that is money that was to be spent; how about cutting down on what you are spending? Austerity, then, continues to be a daydream (See: Burden of debt).

“We have run high fiscal deficits for the last 10 years despite being monetarily sensible for the most part,” reminds Acharya. “There has been no semblance of prudent economic or financial management from the current government.” The new borrowing calendar announced in the FY13 Budget was unnerving as well. The unrealistic revenue projections and record net borrowing had resulted in the 10-year yield hitting 9%. What has pulled the yield down is the open market operations undertaken by the RBI to release liquidity into the system. The other reason that the 10-year yield has fallen lately to 8.32% is increasing expectation of another repo rate cut on June 18, when the RBI meets next.

Burden of debt

Government borrowing has increased even after the economy recovered from the 2008 crisis

Since logic has not been the forte of policy makers of late, it is quite likely that pressure is being brought upon the RBI to take decisions it would refrain from in the normal course of business. The bigger danger here could be politicians impeding the central bank’s independence. Acharya, though, says it will be business as usual.

“The RBI as such is hugely under the thumb of the finance ministry at the moment, perhaps a little bit more than normal times. It has always been the case that when the government has run large fiscal deficits, the RBI has had to scramble to ensure that there is minimum damage,” he says.

For his part, Mecklai says the RBI has been acting pretty much independently but if things get much worse we may see it cutting more sharply than it would otherwise. He reveals, “Since 2008, central bank independence is clearly a mirage; former governor Dr Reddy once pointed out that when things are going well, everybody has their own view. But when things are in crisis mode, everybody needs to — and usually does — work together.” 

For the RBI, too, lowering the interest rate is the only option left, even though it may have wanted to exercise that option once it was clear that inflation is headed lower. For the government, lower rates are welcome as it is, for that may end up pushing the 10-year yield even lower. Says Bank of America’s Mehta, “The best case is we have low interest rate, low inflation and low growth over the next 12 months. In such an event the 10-year yield could drop below 8%, irrespective of government borrowing.” Acharya, though, has his doubts if the going will be as smooth.

Ajay Shah, professor, NIPFPHe says, “I don’t think it is easy for the RBI to majorly reduce short term rates and the medium and long term rates are anyway not in its control, given the state of the fiscal deficit and government borrowing.” Shah, too, is a little circumspect. Everyone who sees the government/RBI engage in one ill-thought-out measure after another worries about India’s future, he says. “A $2-trillion economy cannot flourish when immense powers are placed with individuals and institutions with such weak capabilities. This will further damage confidence and deepen the macroeconomic crisis.” 

The fact remains, though, that in the face of continuing inaction by UPA-II, the RBI can only hope that its rate cutting will revive animal spirits. As a stop-gap arrangement, the central bank also has the option of replicating what it did during the contagion in 1997. At that time, to beef up its dollar reserves, it issued Resurgent India Bonds (RIB).

State Bank of India, too, had followed with India Millennium Deposits (IMD). Mehta thinks that while another round of RIB and IMD will help, a more long-term solution is to widen the debt market for FIIs. He says, “As it is, equity flows were being used to fund the trade gap, so why not use the debt route more aggressively by rationalising the withholding tax?”

Joker in the pack

Meanwhile, everyone, including Mecklai, is watching how the great European monetary union experiment will unwind. He says while Greece will vote to stay with the euro, the problems are much more fundamental. Then he adds, tongue-in-cheek, “The fundamental problem is that Italians are Italian, Germans are German and Greeks are Greek; while there are individual inter-marriages that work, I don’t think it can on a national level.”

This time it's different

The rupee depreciation this year has come about despite stable equity flows, defying the historical trend. Almost always, the rupee has been driven by strong equity flows

Naturally, if Greece votes to stay, the Eurozone uncertainty could continue to linger. And that is not very welcome news either for the rupee or for companies that already are facing demand and cost pressure. Mecklai says, “While 60 to the dollar is a pretty bad scenario, with the European crisis very far from resolution, things could get even worse than this if there is a real freeze up of global growth.” This is a reality Mehta, too, is cognisant of. He adds, “The RBI is intervening in a sporadic manner because using all your ammunition in one shot is not a prudent strategy, especially when you know that the result of the Greek election on June 17 can go either way.”

Jamal Mecklai, chief executive, Mecklai FoundationExpectedly, risk aversion is on the rise. The US 10-year bond yield is currently below 1.50% while the yield of the German 10-year bond is 1.18%. While these returns are hardly exciting, it sure beats the German two-year bond, which investors are holding for free. The yield there is 0.01%. 

In good times everybody can wax eloquent about solidarity and brotherhood, but when times are bad it is each nation for itself. The Eurozone is a monetary union whose flaws are now more than evident, courtesy the profligacy of some of its members. The only way those spendthrifts can live to see another day is if they are absorbed into a stronger balance sheet, of which there is only one. It is highly unlikely that the German electorate will favour its country taking on more freeloaders.

The fiscal union that is being bandied about as a solution is, then, a non-starter. Former French president Nicolas Sarkozy has paid the price and if she continues bleating the same tune, so will German chancellor Angela Merkel. As for the Eurozone, it could pretty soon be something that will be relegated to history books. The only hope for India’s economy now is what is popularly known as the ‘magazine cover indicator’.

What it means is that when the media collectively starts breast-beating about a dismal trend, it has more or less run its course. So, for everybody’s sake, here’s hoping that this Outlook Business cover story marks the crest for all the negative economic news that has inundated us lately.

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