The ostrich and the impossible trinity

The following article appeared on CNBCTV18.com on 21st June 2018

https://www.cnbctv18.com/economy/why-the-monetary-policy-fixation-on-inflation-is-fundamentally-wrong-167031.htm

The ostrich and the impossible trinity

At the June 6^thpost-MPC press conference, the RBI Governor was asked for his views on use of interest rates to defend currencies. His factual response was “(India’s) monetary policy is determined by the nominal anchor that has been given to us through a legislative process, which is the consumer price index”. 

This echoes the mantra of Indian monetarists – focus monetary policy on inflation, and everything else will fall in place.

While it might sound catchy, this simplistic chant downplays many nuances. Amongst them is the “impossible trinity”, which argues that an independent monetary policy will impact currency markets and capital flows – whether intended or not. We saw this play out the last few years, with a flood of reversible, carry-seeking inflows now creating an external imbalance. 

None of the past MPC statements or minutes, including yesterday’s, make any mention of the impact of monetary and intervention policy on currency markets and capital flows. 

Our current monetary policy framework may be simple, focused, and enshrined through legislation. That doesn’t mean it is beyond a critical review. The ignoring of the impossible trinity itself merits a debate.

Monetary policy and currency imbalance

In fiscal year 2018 (FY18), India’s current account deficit (CAD) was $49B, the worst in five years. This was dominated by oil, gold and electronics imports. 

To sustainably bridge this consumption heavy CAD, we need permanent, productive capital flows such as foreign direct investment (FDI). 

Across CAD and FDI, in FY18, the primary balance was a deficit of $18B, against a surplus of $21B in FY17. Export growth in many sectors disappointed, imports rose sharply, and net FDI dropped.

Looking ahead into FY19, on the back of higher oil alone, this primary deficit could rise to $34B, the worst in six years. 

How should we respond to this deteriorating primary deficit? While much depends on global crude oil prices, international trade, and policy measures around our exports, currency markets should offer a natural adjustment as well. The primary deficit should lead to a weaker rupee, and hence lower imports, increased exports, and a lower deficit.

In FY18, instead, INR strengthened in real terms, and that likely hurt our exports and CAD even further. The primary deficit was overwhelmed by reversible capital inflows of $62B, including foreign portfolio investment (FPI) in debt, NRE deposits, net exporter sales, unhedged external commercial borrowings, and just plain speculative positions. 

These flows had a common incentive – the “carry trade”. India offered attractive absolute and real interest rates, alongside the expectation that RBI would curb currency volatility. High yields and a stable currency attract opportunistic and reversible capital flows.

The overall balance of payments (BOP) in FY18 was a large positive, as was the accretion to RBI’s currency reserves. This masked the fact that we were borrowing fickle money to pay our oil, gold and smartphone bills, and increase our currency reserves. 

Between FY14 and FY18, $120B of reversible flows came in. They added to RBI’s currency reserves and eased imported inflation, but led to INR overvaluation, stressed our exports and CAD, worsened our primary balance, and left us vulnerable to rapid outflows if the sentiment turned.

So what could we have done?

We should have monitored this external imbalance, debated measures to reduce carry trades, and considered allowing the currency to adjust to the primary deficit. 

Under the current monetary policy framework, however, when it comes to the external sector, we are neither hawks, nor doves, nor owls – we are ostriches. Witness the complete lack of analysis of the impact of monetary policy on the external sector.

Critics have two sets of arguments against a framework that also considers the external sector. The first is that the simplicity and focus of the existing policy would be diluted with this ‘distraction’. Seriously? Can we really ignore the impossible trinity altogether? 

The second argument is around policy consistency. To reduce the carry trade, we might have had to reduce short-term yields last year. As our macros deteriorated, we then would have had to reverse course. Aren’t the consistent high rates of our current framework more sensible?

To answer this, lets consider global monetary policy. Keeping rates too low for too long, arguably, caused the global financial crisis. The monetary solution to the crisis was even lower rates, for even longer. Do we then commend global central banks for policy consistency across the crisis? 

Likewise, high real rates over the years have allowed an external imbalance to build. As our macros turn, we now have to consider even higher rates and even more currency intervention, just to keep the carry trade from reversing and causing financial instability. 

Policy consistency is not necessarily a virtue, as much as it could be a trap.

Where do we go now?

With worsening macros impacting the carry trade, we have seen $7B of FPI debt and NRE money reverse out in FY19 so far. RBI has had to sell USD in the currency markets regularly since mid-April. 

Of course, not all of the carry trades will move out. The RBI also has currency reserves to cater for outflows. However, it is possible that the stream of outflows becomes a flood, especially if there are further shocks.

It will be easy to blame the next crisis on the next shock. But we must consider what allowed the vulnerability to build up.

We have to let the rupee adjust to the deteriorating primary balance. We also have to explore ways to make some of the carry-seeking flows, such as FPI in debt, more reliable and productively deployed. Importantly, issues facing exporters need to be addressed, even as we somehow start producing smartphones within India. 

Lastly, predictability, consistency and legislative approval may delight traders, but these alone do not make a policy right. There is a case to review our monetary and intervention policy framework, to be at least more cognizant of its impact on currency markets and capital flows.