Raghuram Rajan recently confirmed his exit from the helm of India's central bank. Although markets dreaded the news, both in India as well as globally, the Indian rupee and stock market have shown remarkable resilience so far. Rajan's zeal to fight inflation came under attack from some quarters, mostly India's industrialists and its ruling political class. The Reserve Bank of India (India's central bank) under Rajan's leadership was alleged to be shackling economic growth in what is the world's fastest growing large economy.
In a speech on Monday, the first one after announcing his decision to step down, Rajan debunked all criticism directed at his policies in his own inimitable style. The full text of the speech is definitely worth a read for anyone curious about monetary economics, particularly from the viewpoint of a central banker. Below are some excerpts from Rajan's speech, mainly his views about India's economy and monetary policy. It should help us understand the legacy that he will be leaving behind at the RBI. It is this legacy that will shape India's monetary policy and the Indian rupee's ((NYSE:IFN), (NYSEARCA:ICN), (NYSEARCA:INR) (NASDAQ: INDY), (BATS: INDA)) future going forward.
Fighting inflation above all else
Fighting inflation is not the legacy of Rajan. It is something he inherited from his predecessors in the RBI, all of whom had a single-minded focus towards containing inflation. Yet, when Rajan took charge in September 2013, India's inflation was in excess of 10%. It has now come down to 5.76%, no doubt with quite a bit of help from falling oil and commodity prices.
Throughout, the RBI's focus on curbing inflation remained intact, even while ex-post inflation readings kept falling consistently. As a result, the clamor for abandoning the hawkish stance grew louder with each passing month. Rajan explains why he chose to ignore the popular narrative
"…a central bank serves the economy and the cause of growth best by keeping inflation low and stable around the target it is given by the government. This contrasts with the earlier prevailing view in economics that by pumping up demand through dramatic interest rate cuts, the central bank could generate sustained growth, albeit with some inflation. That view proved hopelessly optimistic about the powers of the central bank."
"There is indeed a short run trade-off between inflation and growth… The short run tradeoff works because economic actors can be surprised by unexpected loosening, and the surprise can have positive growth effects. In the long run, the central bank loses its power to surprise, and the public embeds its correct forecast of how much inflation the central bank will create into all nominal variables such as interest rates. To the extent that high inflation is harmful for growth and welfare, a central bank that continuously tries to give short run positive surprises will entrench long run high inflation, which will be bad for growth."
What is implicit in his comments is the fact that there are limits to the impact monetary policy can have on spurring growth. However, the relationship is not linear, i.e. excessive hawkishness can indeed kill economic growth as Rajan's critics point out. Is this criticism justified? In Rajan's own words,
"the fact that inflation is fairly close to the upper bound of our target zone today suggests we have not been overly hawkish, ... If a critic believes interest rates are excessively high, he either has to argue the government-set inflation target should be higher than it is today, or that the RBI is excessively pessimistic about the path of future inflation. He cannot have it both ways, want lower inflation as well as lower policy rates."
Targeting consumer prices over wholesale prices
Historically, the RBI had given more importance to India's wholesale price index (WPI) while setting monetary policy. In 2013, the consumer price index (CPI) replaced the WPI as the main measure of inflation. This index is a better reflector of the prices the common citizen pays, so the RBI can influence their price expectations more effectively. Moreover, the WPI contains a lot of items whose prices are determined in the international markets, including commodities which have seen large declines in prices. Indeed, India's WPI for May stood at 0.8% while CPI stood at 5.76%, mainly driven by domestic food inflation. Therefore, as Rajan puts it:
"By focusing on WPI, we could be deluded into thinking we control inflation, even though it stems largely from actions of central banks elsewhere. In doing so, we neglect CPI which is what matters to our common man, and is more the consequence of domestic monetary policy."
Positive real interest rates
One of Rajan's most important achievements was to lift real interest rates into positive territory. Surprisingly enough, this fact is overlooked by his critics in India. Before he took charge, India's real interest rates were negative for an extended period of time due to double-digit growth in inflation. This led to a redirection of household savings from financial assets to real estate and gold. Banks had to raise deposit rates in response; yet, the shortfall of private savings could not be bridged and India had to borrow from abroad to fund investments. The result was higher cost of funds for banks, wider current account deficits and lower private investment in the economy. All the while, businesses and the government borrowed at negative real rates. Under Rajan's leadership, the RBI managed to bring down the CPI to mid-single digits, thereby creating positive interest rates in the economy. With India's benchmark 10-year yield currently at 7.5%, real interest rates are close to 2%. Apart from increasing household savings in financial assets, it has also created incentives for better capital allocation in the economy. The benefits of positive real rates should result in stronger growth in the coming months and years.
Monetary transmission remains a problem
This is an argument Rajan has made several times in the past. Reductions in policy rates are not effectively transmitted to bank lending rates in India because of a tiered deposit rate structure. The government continues to mobilize small savings from citizens at higher rates than bank deposits. This restricts banks from lowering their deposit rates in response to the RBI's rate cuts. A similar situation exists with rates paid by quasi government organizations on tax free bonds. However, there are reasons to be optimistic on transmission. As Rajan says,
"I am glad the government has decided to link the rates on small savings to government bond rates, but these rates will continuously have to be examined to ensure they do not form a high floor below which banks cannot cut deposit rates."
Pragmatic policy framework
Rajan also makes the case for intervention in currency markets (which is different from currency manipulation as it's often misunderstood in developed market circles) by emerging market central banks. He says,
"…emerging markets can experience significant capital inflows that can affect exchange rate volatility as well as financial stability. A doctrinaire mindset would adopt a hands-off approach, while the pragmatic mindset would permit intervention to reduce volatility and instability.
Then, he goes on to explain why inflation focus is still the key to reducing volatility. "Nevertheless, the pragmatic mind would also recognize that the best way to obtain exchange rate stability is to bring inflation down to a level commensurate with global inflation."
So what does all this mean for the Indian rupee?
With recent inflation readings coming higher than expected mainly due to high food inflation and rebounding commodity prices, the RBI is unlikely to cut policy rates too much for the remainder of 2016. Moreover, due to an ineffective transmission mechanism, such cuts are unlikely to manifest into meaningfully lower lending rates. Despite this, in the RBI's own words, "the stance of monetary policy remains accommodative", which means policy rates are going to remain in a downward bias.
In contrast, the dollar continues to show strength amid serious macro headwinds and an increasingly 'less accommodative' Fed. Brexit has only compounded these macro problems. We expect these macro headwinds to persist at least in the near future, driving risk off sentiments across the globe.
In an earlier article, we made the case for a weakening rupee. Since then, the currency has fallen 1.5% against the greenback. We continue to see further downside in the coming months.
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