India MPC Preview - A Price To Pay

Interest rates in India have moved up sharply the past 9 months. Oddly, there may be some consensus in both Delhi & Mumbai – for now - that interest rates need to stay high.

High interest rates are the price we pay for a shaky external sector, and a shaky fiscal situation.

Rupee & the likely Delhi concession

Ministers and Babus - who instinctively clamor for 100 bps of rate cuts at any given time – are likely more worried about rupee and inflation this election year. Despite its recent recovery, rupee has weakened by 5% against USD in 2018. Add to higher crude oil prices, and a weaker rupee visibly hurts voters. In addition, we sadly look at rupee strength - mistakenly - as a direct measure of India’s economic virility.

Delhi might concede – for now - that high interest rates are needed to draw inflows and stabilize rupee and inflation.

There are, however, shortcomings to a brute-force interest rate and intervention approach to rupee stability. They come at a high cost, score low on sustainability, and do not address the root cause problems – of rising current account deficits (CAD) and slowing foreign direct investment (FDI).

No one killed exports

Our CAD moved up sharply from $15B in FY17 to about $49B in FY18 – the worst in five years. It could rise further to over $65B in FY19. Besides higher oil prices, we continue to guzzle smartphones and import more gold. In addition, our exports have disappointed – particularly in gems and jewelry, and in textiles.

Global trade was robust in FY18, despite all the headlines around protectionism. While India’s imports rose by 21%, our exports grew only by 10%. Was this relative export underperformance a one-off because of teething GST issues & the ongoing cleanup in gems & jewelry? Or does an overvalued INR also hurt our CAD?

Borrowing to pay today’s oil bill

As a country, we have to borrow foreign currency to finance this growing CAD.

Ideally, we need stable flows such as FDI that lead to productive investments. However, our net FDI actually fell from $36B in FY17 (till Feb) to $29B in FY18 (till Feb).

For the first time since FY13, in FY18, we had to borrow from less-stable sources just to meet our growing CAD.

High interest rates alongside an implicit RBI insurance against rupee volatility can bring in opportunistic, carry seeking flows. But they come at a cost, and the reversibility of carry flows can make it difficult to deploy them into productive long-term investments.

We have to do better than hope that oil prices eventually fall, or that our kids’ ingenuity will allow them to pay for today’s oil bills.

Give industry a chance – on the currency

Permanent flows – CAD and FDI – do not change overnight. However, a weaker INR – alongside solutions to ground level issues - can help domestic industry replace imports, and export more. From a high of 121, the rupee real effective exchange rate (REER) has now dropped to 115. It’s still high.

Sadly though, a headline USDINR of say 70.00 may not be politically acceptable for now. Of course, if crude oil prices rise to $100, the market will not wait for Delhi’s permission to take it there.

The solution is higher rates – now, what was your problem again?

In sharp contrast to Delhi, that's the motto of the Mumbai monetarists.

Mumbai monetarists will be positively beaming this week. They will keep it simple, and avoid ‘distractions’ such as the rupee. They will expound on rising headline and core inflation, and preach eternal monetary vigilance. Never mind that we have no idea where our food and commodity price dominated inflation will be in 12 months time. Never mind that research suggests that higher interest rates might at times add to the inflation problem in the Indian context. After all, unlike our government, all of India borrows rupees much more to produce, than to consume.

But the monetarist panacea will be simple and consistent as ever – tighten liquidity, and keep interest rates high. 

The financial stability junkie’s perspective

Finally, financial stability junkies (like me) will also broadly agree with the monetarist medication, considering the current context around quality of our fiscal deficit, the external sector, and other domestic and global uncertainties.

We have covered the external sector earlier.

Is fiscal deficit such a big deal? After all, the center’s fiscal deficit has improved from 4.5% of GDP in FY14 to 3.5% in FY18, and is budgeted at 3.3% for FY19.

The fiscal bounty from low oil prices

All of the reduction in fiscal deficit between FY14 and FY18 – and more - came from increased oil revenues to the government. In FY14, the center’s net revenue across excise and subsidies on petroleum products was 0.2% of GDP. By FY18, that rose to 1.2% of GDP. This does not include the rise in customs duties, corporate tax collections & dividends from oil companies, or the state government’s VAT collections.

In INR terms, average FY19 price of crude oil is up by over 30% from FY18, and the oil fiscal bounty is under threat.

Borrow, cut junior’s tuition classes, and increase household spending

While FY18 fiscal deficit ended flat at the FY17 level of 3.5% of GDP, the revenue deficit – money borrowed just to meet regular expenses - moved up from 2.0% of GDP in FY17 to 2.6% in FY18. In turn, capital expenditure came down even in absolute terms – from INR 2.9T in FY17 to INR 2.64T in FY18. This is akin to a household doing what the sensationalist caption above suggests.

Our FY19 fiscal deficit could go the same way.  We will likely exceed the 3.3% deficit target by 0.2-0.5% of GDP. While GST and formalization will pay us rich dividends eventually, the revenue projections for this year are ambitious. We will also have higher doles and MSPs to assuage restive voters. Lastly, the impact of oil prices remains a very real risk.

We haven’t even talked about farm loan waivers or hidden fiscal costs such as ongoing bank recapitalization or the UDAY scheme. Much like the case of the external sector, when we start to borrow to pay today’s regular bills or buy votes without a sustainable investment model, there will be a price to pay.

Cut to the chase

The MPC (RBI) will likely adopt a tightening stance, hike rates by 25 bps each in June and August, and eventually let INR liquidity tighten.

With both 5y and 10y bonds at 7.85%, markets have priced in all of this. Yet the somber mood will not lighten.

As with any medication, high rates will have their side effects. NBFCs have grown very large balance sheets, and the quality of their books will be tested. Bank balance sheets have anyway given up long ago. Higher rates and financial instability could also test equity markets. For now, robust domestic flows chasing the “mutual funds sahi hai” dream have made light of traditional valuation models. If that treadmill of flows were to ease, that could spawn a whole new horror story.

But as long as some of us borrow unsustainably, both locally and internationally, to fund current expenditures, someone has to pay a price.