National Council of Applied Economic Research
Opinion: Poonam Gupta
For now RBI should be comfortable letting it slide (gently if it so wishes) by another 5% in the coming months and even more if the external market pressure continues.
Global capital flows have been retrenching from emerging market (EM) economies since end-February in the wake of Russia’s invasion of Ukraine. Another factor for this situation is the higher-than-anticipated persistence of inflation in advanced economies which is expected to continue to dictate the monetary policy globally. Also an oil and commodity price shock has aggravated the situation for countries that are net importers.
Circumstances have been ripe for global investors to fly to safety – to rebalance out of large EMs such as India Brazil Indonesia Mexico South Africa and Turkey into the US and other advanced economies. The immediate impact of this rebalance is being felt by EMs on their currencies equity markets and bond yields.
Have global developments had a disproportionate impact on India?
No as most other countries have faced similar implications. In some ways the shock itself has been harder for India than many other countries because of it being an oil importer a reasonably integrated economy through trade and a large recipient of capital flows in the last two years.
Yet it has so far escaped the worst obvious from the rates of depreciation of the exchange rate during end-February 2022 till now which have been as high as 20% in Turkey 17% in Chile and 11% in Thailand. Even South Africa at 9% Brazil at 8% and the Philippines also at 8% have experienced higher depreciation rates than India (6%) during the same period. Only Malaysia at 5% and Indonesia at 4% have lower rates than India.
Similarly equity markets have taken a hit across almost all the large EMs. The decline in equity prices has been 12% each in South Africa the Philippines and Brazil; 10% in Malaysia; 9% in Thailand; and 8% in Mexico. The decline in India has been 6%.
Has India’s response been in the desired direction? Of the desired magnitude?
In the right sequence?
In a 2018 World Bank working paper Oliver Masetti and I analysed the policy kit that central banks in EMs use to handle such external volatility. This tool kit comprises monetary policy exchange rate foreign reserves and capital flow measures. We found that of these the most readily used measures are monetary policy exchange rates and foreign reserves. The capital flow measures are used sparingly.
Nudging Forward
It is in this context that Reserve Bank of India (RBI) measures announced on July 6 assume significance. For the most part RBI’s response as well as the pace and sequencing of the measures undertaken has been as per expectations. It has refrained from using any capital flow measures until now but has tightened the policy rate twice has let the exchange rate depreciate by about 6% and has used up nearly 7% of its foreign exchange reserves to ensure an orderly adjustment of the exchange rate.
RBI also relaxed the norms to attract foreign investment into NRI deposits corporate and government bond markets and external commercial borrowings. Most of these relaxations are for a temporary period – from end-October to end-December. All these measures are reasonable and can easily be extended or made permanent based on the experience in the interregnum.
So has the exchange rate peaked?
What else can RBI do if the capital flow reversals continue?
Much would depend on the duration of the period of instability. If it lasts for a few more months the toolkit will shrink somewhat.
It’s advisable to use reserves somewhat sparingly lest the generic reserve adequacy ratios start looking somewhat unfavourable. Monetary policy tightening is widely expected to continue both in response to domestic inflationary conditions as well as for coping with the monetary policy tightening undertaken by the US and other EM economies.
However there is room for the exchange rate to depreciate further. As noted above the exchange rate depreciation in India has been more muted than in the other large EMs. Under the circumstances the exchange rate ought to be treated as an automatic stabiliser and needs to be embraced. It is quite likely that the exchange rate may overshoot – as it often does under such circumstances – and we should let it. A competitive exchange rate itself can boost both capital and current account inflows.
For now RBI should be comfortable letting it slide (gently if it so wishes) by another 5% in the coming months and even more if the external market pressure continues.
The tool of liberalisation of capital flows can be deployed further both for its signalling value as well as to materially attract new capital and to front-load the impending remittances and capital inflows. Besides the narrative of domestic reforms must continue unchecked. Inspiring confidence in domestic policy frameworks and adherence to fiscal prudence need to stay the course too. In addition we need to focus relentlessly on raising non-tax revenues to pump-prime the economy should the need arise.
Right Reaction
During past such episodes RBI has also signed or extended bilateral swap lines with Japan. Even though these swap lines are considered to be generally untested – and possibly ineffective – they may be worth considering if the period of turbulence extends beyond another 2-3 months and if the reserves decline by another 5-7% during this period.
Hopefully calm will be restored before that due to both external conditions and India’s policy response in the meantime.