Currency, banking and finance – in search of the right policy mix

The following article appeared on CNBC TV18 online on October 4, 2018

https://www.cnbctv18.com/views/rbi-monetary-policy-credible-tight-monetary-policy-isnt-currency-defense-to-draw-in-more-flows-989631.htm

Currency, banking and finance – in search of the right policy mix

Taking Stock

The powers-that-be in Delhi & Mumbai are in an unenviable spot. 

The global context is gloomy. Brent crude oil has moved well past $80. Global central banks are withdrawing monetary accommodation. The impact of Iran sanctions, trade wars and populism are still playing out. Analysts are (predictably) warning of worse to come.

This brings our financial stability vulnerabilities into sharp focus.

First, the imbalance in our currency market persists. Our current account deficit (CAD) could balloon beyond $80B this year, even as the large open positions in rupee, built up by our high real rates of the past, nervously ponder the exit door.

Second, our banking sector continues to struggle with non-performing assets (NPAs). While there is now recognition of the NPA problem, we are still kicking the can on resolution, full bank recapitalization, and meaningful reform. This is now spilling over to the broader financial ecosystem, with ominous whispers around NBFC, HFC and asset manager liquidity and asset quality. The investment cycle that we need is not even on the radar.

Finally, we have our own domestic uncertainties. Elections are imminent. While the Finance Minister has specifically promised to stick to this year’s fiscal targets without compromising on capital spend, the math looks incredibly tough.

Authorities must be inundated with entreaties, warnings and suggested prescriptions around the current state of affairs. Let me add to the din with my own prognosis – of short-term and long-term steps that we should consider.

The short-term steps

First, in the aftermath of the IL&FS default and subsequent scare around fund, NBFC and HFC liquidity and asset quality, any possibility of needless panic in credit markets needs to be put to rest. RBI and SEBI should facilitate liquidity to funds against good quality corporate debt, by in turn providing a special funding window to banks. This was provided in 2008 and should be considered now.

Regulators can have legitimate issues against such a window – this is not 2008, and they have no obligation to backstop liquidity to entities that have arguably grown too rapidly in recent times. Having said that, the ecosystem as a whole is responsible for this situation where secondary and repo volumes are small in relation to outstanding debt. There are more sensible ways to pass a stern message or address core issues around liquidity, credit ratings, valuation and governance, than through a potential credit squeeze and panic with possible ramifications to the wider economy.

Second, having nipped any immediate corporate bond liquidity issue, lets turn to the distinctly different issue of lower government bond yields and higher banking liquidity.

RBI has always provided ample banking liquidity through short-term repos. There are now a few calls for CRR cuts and/ or large-scale RBI purchases of government bonds (OMOs) to inject durable liquidity and reduce bond yields.

Of course this would provide relief to our beleaguered financial services industry. But it would also endanger our brittle currency markets, and the costs could outweigh any short-term benefit.

In FY19, we could have core outflows of $50B across CAD and foreign direct investment (FDI). Despite recent reduction, we still have over $100B of open currency positions that were put up since FY15, attracted by our high real interest rates.

In short, we are now holding the currency tiger by the tail – having kept rates high in the past and drawn in $120B of reversible flows and positions between FY15 and FY18, we’re trapped into keeping rates still higher and preventing their rapid reversal. Credible tight monetary policy isn’t “currency defense” to draw in more flows – it’s an imperative to prevent hemorrhage.

Even if headlines policy rates are hiked alongside, CRR cuts and large scale OMOs can dent monetary and currency credibility, as some emerging markets have discovered.

Also, given the nature of our external balance, high GDP growth and high consumption are not good news for now. These could increase imports and further pressure the currency. Unpopular as it sounds, we may have to sacrifice growth for now with high interest rates, demand curbs and fiscal austerity.

In summary, suggest we should provide liquidity support to corporate bond markets, be hawkish on monetary policy, be fiscally austere, and use our currency reserves to stave off any panic. Much of this will be deeply unpopular and will defy realpolitik – but avoiding these may eventually risk a hard landing.

The medium-term

The above steps will only buy us time without addressing the core issues around our CAD, health of the financial sector and the absence of an investment cycle. Within this time, we must address these issues head-on.

The current account should hopefully see some improvement over time, with the weakening of the rupee this year. Additionally, unless the strategy is to pray for an eventual drop in crude oil prices, we must make ‘Make in India’ and ‘Make for India’ operative. Industry experts have provided many specific medium term suggestions around this.

On the financial sector, we need to resolve stressed assets, recapitalize banks, and implement the P J Nayak committee recommendations. NBFC operations need a separate review altogether. Alongside, we have to address the issue of liquidity and infrastructure in corporate bond secondary and repo markets.

What about inflation targeting?

How does the above prognosis fit into MPC’s inflation targeting mandate, given headline CPI is below 4%, and has trended soft for 3 months now?

Short answer – legislative mandates cannot overturn basic economics.

With its inflation mandate and blinkers, none of past MPC statements have even referred to the impossible trinity - the proven connect between monetary policy, capital flows and currency markets. 

This is a pity, because with a richer debate, we should have recognized early that our high real rates were attracting reversible, expensive foreign currency flows, increasing the quantum of reserves without improving its quality, overvaluing the rupee, and funding our rising oil and smartphone consumption bills. This unsustainable external balance has led to our current currency stress.

We would compound the issue by continuing to ignore the impossible trinity and financial stability now.

If we still want to stick to inflation targeting (as MPC must, sadly, given its legislative mandate), suggest we find a spreadsheet that projects inflation down the road at well above 5%. We could use weaker rupee, higher domestic fuel prices, and increased tariffs to make this case.

To FCNR or not to FCNR now

First off, $400B of reserves is not small. If we show weakness now and look to raise expensive money, we’re basically resetting $400B of reserves as the new zero. Even with $50B of core deficit and another $50B of capital outflows from here, we’re still talking of an annual outflow that’s just 25% of our current reserves. We have enough reserves and the fallback of unconventional measures to buy us time, as long as we hold our nerve and credibly address root cause issues.

Second, from the RBI and Government’s perspective, the 2013 FCNR scheme effectively raised US$ at 4% over US Treasury. While the cost was obfuscated, this is NOT cheap, and everyone in the supply chain – the overseas banks, the NRI and the local banks – made supernormal profits.

Third, the scheme itself needs a review. This did not bring in NRI money – it brought in bank money that pretended to be NRI money. If at all we have to go down the path, we have to make this scheme more less preferential to one constituent, more fairly priced, and less of a distortion.

Messaging

The messaging from regulators & the government should be clear – exude unity and calm, reiterate our ample strengths, honestly acknowledge issues around our external balance and financial ecosystem, provide credibility and comfort with a credit market window, keep monetary and fiscal policy credibly tight, and use the time and goodwill that we still enjoy to address the real issues in our exports, manufacturing, current account and financial sector head-on.

Poor messaging, cross-talk, blame games, and shifting policy stance depending on who last walked the corridors of power can convey the sense that authorities do not have the understanding, ability or willingness to do what it takes. A version of this happened in 2012-2013. We should guard against a repeat.