The Reserve Bank of India Is Changing Again

While RBI’s central board has certain powers, these have been rarely used to oppose finance ministry action

Time was when the Reserve Bank of India (RBI) resembled more a Soviet rationing officer than a conventional central bank. Mercifully, 1991 and economic reforms ended all that; the RBI got down to conventional central banking, which included moving the economy slowly out of administered interest rates, ending automatic monetization of government debt and shrinking its autarchic footprint. After a 26-year hiatus, there are misgivings that RBI could be lapsing into some of its old habits.

In the now defunct central banking format practised by RBI, all credit over Rs1 crore was rationed. Under a scheme called Credit Authorization Scheme, the RBI vetted all large loan proposals. Even though the floor was raised gradually over time, RBI continued to have a say in how much banks could lend to whom, and at what rate. The RBI was also the implementer (and custodian) of the government’s illiberal measures: banks had to compulsorily invest 40% of deposits in low-priced government securities and keep 20% with RBI as a cash reserve. Of the balance 40% left for lending, 40% had to be mandatorily lent at concessional rates, leaving “commercial” banks with only 24% of deposits to play around with. No wonder average lending rates ranged between 16-18% and non-performing assets were rarely recognized, leave alone provisioned.

These are now part of the nation’s sepia-tinted economic history. The RBI has been easing controls for the past 26 years, even though it has retained numerous other controls as part of its mandate to ensure monetary and financial stability. The overall process has not always been smooth or linear. Economic disruptions, both exogenous and endogenous, have occasionally forced the RBI to slow down or undertake course correction.

In recent months, there are suspicions that RBI’s reform mandate may have changed. The central bank’s role in the demonetization exercise sowed the first seeds of doubt. While the RBI’s central board has certain powers, these have been rarely used to oppose government action. Then, as well as now, the RBI would have gone along with the decision. But, here’s the crucial difference: governor and deputy governors could have used different platforms to speak their mind about the extreme decision. They would have made attempts to explain the economic shock to citizens. Instead, RBI’s March report on the macro-economic impact of demonetisation is an exercise in politesse.

Perhaps RBI doesn’t want to speak out because collateral damage from demonetisation has kept it incredibly busy.

Demonetization led to a liquidity surge, forcing the RBI to step in. Banks had no alternative route to deploy this liquidity, given the uncertainty created by demonetisation and industry’s non performing assets (NPA) induced aversion to bank credit. The RBI implemented a four-stage liquidity management programme, using different instruments at different times. Surplus liquidity also depressed debt yields. Around the same time, on 14 December, the US central bank Federal Reserve raised interest rates leading to outflow of foreign portfolio investment (FPI) from Indian debt markets—Rs46,087 crore went out during the last three months of 2016. This continued in January too. Consequently, the rupee-dollar exchange rate also mirrored these trends, depreciating initially and then staying range-bound for a month.

Then, suddenly around end-January, yields on the 10-year government bond started perking up. Foreign portfolio investment inflows also rushed in—Rs51,679 crore during February-April. By end-April, the rupee had also appreciated by almost 6.5% from the lows of 24 November.

The rupee’s appreciation has hurt exporters. But, more importantly, a 6.5% movement in such a short time is a sign of untreated volatility and should have been countered by the RBI. But, tackling the demonetization-led liquidity surge has probably left the RBI with little or no fire-power. Ordinarily, faced with such a predicament, the RBI would have used another weapon: talking the market down. But, neither the RBI governor nor his deputies has spoken a word over the past few months.

Two conclusions arise: either the RBI agrees with the current rupee value (which most economists think is over-valued) or it is scared to speak out. The government’s distaste for former RBI governor Raghuram Rajan’s public speeches was well publicized. RBI’s top brass has delivered only nine public speeches between January and May this year, compared with 23 last year.

Management of stressed assets is another example where the RBI seems to have abandoned characteristic central bank detachment. The RBI is stepping into the mud-pit of stressed assets to help banks recover sticky loans; this includes even taking commercial decisions regarding selection of credit rating agencies. This could expose RBI to serious risk, including reputational risk.

It might be instructive here to recall how Rajan spent his last days in office staving off pressure from the finance ministry, which insisted that the RBI use its balance-sheet to recapitalize public sector banks. At that time, deputy governor Viral Acharya (then professor with Stern School of Business) had criticized it in a Bloomberg story, saying, “At a minimum, it looks opaque and devious…could be perceived as an attack on central banking independence.”

At a time when globalization is in peril, the RBI seems to be voting for a dubious global trend: ceding autonomy to the political executive without a fight.

The above article was first published in Mont newspaper on May 31, 2017, and can also be read here

The Great Indian Rupee Trick - Redux

A lot has already been written about why the Indian rupee has gone into a free-fall. Some of it is utter nonsense, such as stuff which claims rupee should actually be appreciating instead of depreciating. But, otherwise, the narrative has mostly been sane and restricted to the straight and narrow.

What, however, does not get written is Indian government's strategic intent, or the lack of it. Most analyses tend to paint the Indian government as a hapless bystander, hit athwart and stunned by debilitating global financial flows. The fact is this: the portends were strewn in the four winds many moons ago. But, our policy makers were busy frying other fish.

Authorities have been blaming "global conditions" for the rupee volatility. This is an euphemism for Federal Reserve Bank's loud thinking about ending its accommodative monetary policy, or now known as "tapering" in the international bond markets. In essence, it implies the Fed is thinking aloud about when to start reducing (or tapering off) its $85-billion-a-month bond buying programme. 

Arguably, if this does materialise (as some are convinced that it might in September or October), then interest rates in the USA are bound to rise from their current near-zero levels. Plus, that would also imply an improvement in the US economic prospects, because the Fed has categorically stated that it would "taper" only if unemployment rates fall and inflation bumps up.

Now, given all the problems with the Indian economy -- widening current account deficit, slowing economic growth, stubbornly high consumer inflation, stagnant industrial production, a spike in short term foreign debt, growing reliance on populist measures, corruption scandals and impending elections -- the US bond market definitely looked more interesting. Therefore, as soon as news started filtering in about "tapering", investors dumped Indian stocks and bonds and rushed to get back into dollar assets, such US treasury bonds.

This rush to sell Indian assets, take the rupees and exchange them for dollars, created a spike in demand for dollars, leading to the rupee's fall. As the rupee started to fall, more investors started getting out because staying on would mean a further erosion of yields. This self-perpetuating crisis was fed a bit of fuel by emergency measures implemented by Reserve Bank of India.

One leg of the strategy should have been to encourage flow of foreign direct investment which is typically sustainable and long term in nature. But they made a complete mess of it.

But the point here is that the Fed has been talking about "tapering" for quite some time. Sample Fed chairman Ben Bernanke's testimony to the joint economic committee of the US Congress on May 22: "At its most recent meeting, the Committee made clear that it is prepared to increase or reduce the pace of its asset purchases to ensure that the stance of monetary policy remains appropriate as the outlook for the labor market or inflation changes." (read it here)

On the same day, the Fed released the minutes of the meeting of the Federal Open Markets Committee (the round table of Fed knights that sets the interest rate) held on April 30 and May 1. This is the paragraph that showed up on investors' radars with a loud bleep: "Participants also touched on the conditions under which it might be appropriate to change the pace of asset purchases. Most observed that the outlook for the labor market had shown progress since the program was started in September...A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome. One participant preferred to begin decreasing the rate of purchases immediately..." (read the full text of the minutes here)

Fed chairman Bernanke testimony to the US House of Representatives on July 17 had similar strains (read it here). Please note: he never once mentioned that the Fed had decided to withdraw the accommodative measures, leave alone finalising a date to begin the tapering off. He only reiterated that the economy was doing well, there was still some distance left to cover, that the expansionary strategy would continue even after Fed began  "tapering off" and so on.

In addition, many Fed governors had been debating the same point -- about the appropriate timing of the Fed's "exit strategy" -- in their various speeches for months. 

It is, therefore, surprising that while the whole wide world, its grandmother and all the portfolio investors could feel their antennae tingling, the Indian government and its various policy-making arms were oblivious to these developments. There was no counter-strategy, no emergency measures. Nothing.

Forget the past six months. Ever since Fed launched its expansionary monetary policy and flooded the global markets with excess liquidity, it was well known that this money would flow back as soon as there were hints of increases in US bond yields. And, yet they dithered. 

A columnist in Washington Post also said:  "The Fed has telegraphed the tapering and eventual end of its QE policies with with increasing specificity for months now, so you would expect, in a perfectly rational world, for currency and bond markets to have long ago priced in plans of Bernanke & Co. The wild thing about the most recent bout of market volatility in the last few weeks is there's been no earth-shattering news about the prospects for the Fed tapering and then ending its bond purchases. Both US economic data and comments out of senior officials have been broadly consistent with where they were a month ago." (read the column here).

There's only option left now: pray.

Sir, Your Talk Time's Over...

Prime Minister Manmohan Singh, on June 6, announced a long list of projects that, when completed, can be expected to rejuvenate the economy's mojo. The markets -- already enthused by Reserve Bank deputy governor Subir Gokarn’s statement on rate cuts -- took heart from PM’s statements. In an economy devoid of any feel-good news and wracked by a steady stream of depressing developments (low GDP growth, a resurgent inflation rate, depreciating rupee, corruption, policy inaction), these two events were welcomed quite like the delayed monsoon clouds.

But it is primarily the PM’s statement that provides some hope to many beleaguered market operators. In short, the PM has proposed investments of over Rs 100,000 crore in various infrastructure projects across various sectors – such as, roads, power generation, coal, ports, aviation and railways. Read the full press release here and here.

The plan sounds grand and has all the right ingredients to lift the economy out of its current slough.

But -- and sorry to sound like a wet blanket -- market operators seem to be in for a big disappointment. What’s wrong with what has been announced? Technically, nothing. The economy needs large doses of investment at this juncture to pull it out of the morass and the recent declaration seems to fit the bill. But, such announcements have been made even in the past. Like earlier occasions, this time too, the government has trotted out only a large string of impressive numbers, but has failed to mention a couple of crucial facts.

Point One: Who, in the name of blazing heavens, has this kind of money today to invest in infrastructure projects? The government is already highly leveraged and is liable to get tripped by the market if it tries to borrow over and above its budgeted expenditure. The only way it can free up some cash is by cutting down on some items of non-plan expenditure, such as wasteful subsidies. But, as everybody knows, that is still a long shot. Even the private sector is hamstrung, with profits falling for FY12 and the continuing slowdown spooking all investment plans.

The only option left is overseas funding. But, the government needs to use the broom vigorously to clean up multiple acts before a single cent rolls in. For instance, there needs to be a serious rethink on external debt ceilings if the private sector is expected to pitch in with funds and expertise. Second, the government might need to use innovative structures to fund such projects without impacting the overall deficit numbers. (One can read ICICI Bank chairman K V Kamath’s interview for some ideas).

Point Two: Time to repeat the point that was made earlier. Such announcements have been often made in the past but without any follow-up on the achievements. In this case too, there seems to be no clues on how the government proposes to achieve these targets.

There are numerous reasons for the proverbial slip. For one, ministers handling the infrastructure portfolios are not schoolchildren in thrall to the headmaster or employees beholden to an autocratic boss. So, it really doesn’t matter whether they perform or not. These ministers are where they are because of other reasons. They have been elected to power and are holding a particular economic portfolio at the behest of the party chief and not the PM. Or, they are in the cabinet because they are part of the ruling coalition and helped UPA-II to stay on in power. Look at the empirical stuff: barring the ones facing criminal proceedings, not a single minister has been penalised for poor performance. Some have been merely shuffled off from one “lucrative” ministry to another.

Also, as has been seen on numerous occasions in the past, large projects are usually dogged by several problems: clearances, approvals, financial closure, regulatory hurdles. Add to that another malaise affecting most projects in India: the pay-off syndrome. Most large projects in India need to make pay-offs at multiple levels – at the central level, at the state and at the local municipality level. This adds to costs and, in many cases, renders the projects unviable. Inability to pay at any one level can delay the project irretrievably.

Do we have any word from the PM on how he’s going to block these malpractices? Nope. Any clues on how he proposes to give that all-important push to the projects? An investment tracking system has been set up (read here). Will that be that enough? As the cliché goes, only time will tell.

So, finally, how do we approach such announcements? I’d say hold the celebrations.