A good start would be to unwind R-protection measures
Given how bond yields have surged to near-Lehman levels of over 9% (Monday’s yields were 9.24% versus 9.47% the day Lehman Brothers went under) and the rupee falling by 146 paise in one single day—since RBI’s July 15 rupee-rescue measures, it has fallen 323 paise—it is obvious RBI and the central government need to junk the current plan that is causing more harm than good. Had RBI not stepped in to help the rupee, it is possible its further fall would exacerbate inflation through costlier imports—though the extreme economic slowdown makes a full pass-through difficult—which would, in turn, have led to interest costs rising. Such a rise, however, would have been dramatically lower than the 200bps shock RBI gave on July 15 as a result of which 10-year yields are up 168bps as liquidity throughout the system has been sucked dry—call rates have risen from 7.21% to 10.33%. Though the current plan clearly has the blessings of the finance ministry which includes the Governor-designate, a change of guard offers a convenient cover for jettisoning it. While it is not certain that this will stabilise the rupee, the current policy clearly isn’t—a return to status quo ante, on the other hand, may just have a positive impact since a return to reasonable liquidity can help stabilise consumer demand to some extent and lower pressure on corporate balance sheets.
Even if it doesn’t, incoming Governor Raghuram Rajan needs to jettison the current policy for a variety of other reasons. Come September 30, if bond yields stabilise at even current levels, banks could be looking at mark-to-market losses of nearly R50,000 crore—in the case of banks like PNB, a Credit Suisse study estimates, every 100 bps increase in bond yields affects PBT (FY14E) margins by 21% and 8.6% in the case of SBI. Two, whether interest rate cuts stimulate either consumption or investment is irrelevant, continuing with high interest rates will result in increasing NPAs and loan restructuring for banks. Three, if each new move by RBI is seen as being the result of earlier moves not working, that only sends panic signals in the market as to what harsher measures the future will bring—as Governor, Rajan needs to bring a halt to that negative self-fulfilling perception cycle.
While the government seems to believe the rupee’s collapse is unadulterated bad news, the reality is more nuanced. While using just one data point—July exports growth of 12%—to say exports are responding is premature, imports have contracted sharply. Non-oil, non-gold imports have fallen from $72.3bn in Q3FY12 when the rupee was 50.9 to the dollar to $64.4bn in Q1FY14 when the rupee was 56.7 to the dollar; Q2 will likely show an even sharper fall. Two other datasets are important. Exports of ores which used to be around $8.5bn annually till FY12, were just $1.3bn in Q1FY14—in other words, a big chunk of exports has collapsed and needs to be restored. Simultaneously, while annual coal imports were around $9-10bn from FY09 to FY11, they jumped to $17.5bn in FY12, were $15.9bn in FY13 and will probably be at that level in FY14. Getting coal imports down through allowing more private miners and getting the Supreme Court to relax the ban on exports has to be a big priority for the government in its effort to balance the CAD. If exports don’t respond quickly and/or the quasi-sovereign bonds don’t materialise in a few weeks, the finance ministry may need to revisit its objection to looking at the IMF for help—with the rupee below its fair value based on BIS data, a further fall in the rupee will not be based on fundamentals but on perceptions.