MAVERICK VIEW. Interest rates — time to change course

At long last the US Fed has undertaken a predictable lift-off of its rates from 0-0.25 per cent to 0.25-0.5 per cent. The Fed had prepared markets and there was hardly a ripple in exchange and financial markets. Whatever be the number of Fed increases in 2016, it is clear that there is a directional shift in Fed monetary policy. Sooner or later there would be outflows of portfolio capital from emerging market economies (EMEs).

The Indian authorities claim that that they are well prepared to face the changing international financial environment. Nonetheless, we need to ensure that exchange rate and monetary policies are in sync.

Both, official and public preoccupation is with the US dollar-rupee rate and there are screaming media headlines such as “Rupee breaches 67”. What matters is the real exchange rate, that is, the nominal exchange rate adjusted for inflation rate differentials.

Till 1997, the Reserve Bank of India (RBI) used as a pole star the Real Effective Exchange Rate (REER), that is, a trade-weighted nominal exchange rate adjusted for inflation rate differentials. Initially, two models were used, namely, a 5-country model and a 36-country model.

But after 1997, the RBI was somewhat disenchanted with the REER on the ground that the trade weights do not take cognisance of services, and shifting the base year gives varying results. Thus, the RBI shifted its emphasis from the REER to ‘control of volatility’. While control of volatility is desirable, it does not make for a comprehensive exchange rate policy.

The RBI does, however, continue to publish the REER based on 6-country and 36-country models. The October 2015 REER shows an appreciation of 10 per cent on the 6-country model and 24 per cent on the 36-country model. Again, a simple adjustment of the nominal US dollar-rupee exchange rate for inflation rate differentials would point to the need for a competitive exchange rate of around $1=₹71-72.

Since January 1, 2015, the depreciation vis-à-vis the US dollar has been: Brazil (45 per cent), South Africa (33 per cent), Russia (23 per cent) Mexico (18 per cent), Korea (8 per cent) and India (6 per cent).

The RBI has developed skills in dealing in the spot and forward markets, and more recently has been testing the waters in futures, options and non-deliverable forward markets. Central banks always face the danger of speculators trying to ‘break the bank’ if the central bank is too open about its exchange rate strategy.

Intervention is a tricky operation and a central bank needs to be sure that it is fighting speculation and not a fundamental disequilibrium. Once a central bank is sure about its assessment it should hold its nerve and confidently intervene in the forward market to crush speculation. This is easier said than done. At the present juncture, there are many indicators pointing to the rupee being overvalued.

Indian exports, particularly micro, small and medium, are clearly on a decline, and imported goods are swamping Indian domestic markets. In the ensuing period, the RBI would do well to hold its powder dry and intervene to stop a depreciation of the rupee only after it is totally sure that markets have depreciated the rupee excessively.

China has set up a new 13-country exchange rate index. The RBI should undertake an indepth study on the construction of this index. The US dollar has a weight of 26.4 per cent in the Chinese index while in the SDR the dollar has a weight of 41.7 per cent. Some analysts claim that the Chinese yuan is overvalued by 14 per cent and there is a strong possibility of a large outflow of portfolio capital. When the yuan depreciates against the dollar it will put pressure on the Indian rupee.

Hardly had the dust settled on the US Fed rate hike when there was a clamour that Indian interest rates should be lowered. With the progressive increase in the US Fed funds rate, it would be sheer harakiri to reduce RBI policy interest rates. The RBI should not remain accommodative. It should be made clear that we have reached the end of the interest rate reduction cycle.

With the regulations on marginal costing coming into effect from April 2016, if the authorities persist with policy interest rate reductions, deposit interest rates will fall precipitously and adversely impinge on total savings and growth. It is in this context that the RBI’s February 2016 policy announcement would be crucial.

The choices are clear. If we wish to have a strong rupee and low interest rates, we should be prepared to have a massive outflow of portfolio capital. This will call for severe measures on both the rupee exchange rate and monetary policy. The more sensible course would be to allow a gradual depreciation of the rupee and calibrated increases in policy interest rates which would minimise the portfolio capital outflow.

Tailpiece : The excellent mid-year Economic Review of the ministry of finance suggests a lower GDP growth rate of 7.0-7.5 per cent as against 8.1-8.5 per cent hitherto. The review, however, hints at the need for lower interest rates, a less rigorous target for reduction of inflation and also postponing the fiscal correction target.

While this may appear to be imperative from the need to stimulate growth, it also implies a resurgence of inflation and a depreciation of the rupee. These signals are worrisome as it ultimately will lead to policy inconsistencies resulting in a weaker macroeconomic performance and greater suffering for the masses.

The Centre should take a hard look at these implications.

The writer is a Mumbai-based economist

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