From RBI to Fed, communication strategy critical
Though two press conferences, one by the finance minister and the other a joint one by the RBI Governor and his successor, were meant to clear the communication between the government and the markets, economy watchers ended up getting more confused. While the finance minister reiterated his situation-under-control message, throwing in statistics that buttressed his point, the RBI press conference confused matters. Despite the rupee falling from 59.9 on July 15 when RBI began its rupee tightening to 64.63 yesterday, Governor D Subbarao reiterated RBI had done the right thing and that no one really knew what would have happened had it not intervened. While Subbarao’s statement was along expected lines, what confused matters is that on Tuesday, the day after Governor-designate Raghuram Rajan joined RBI on deputation prior to taking over, RBI issued a circular suggesting some rethinking since it talked of the need to look at growth. Theoretically, RBI can try to keep rates high at the short end of the market to discourage speculation while conducting open market operations to keep long rates low to stimulate growth, but the reality is this hardly works. Which is why 10-year rates rose from 7.56% on July 15 to 8.23% yesterday—banks are increasingly raising their base rates due to this. More important, even if short-end rates rise to 12%, this means the cost of speculating on the rupee are just 1% a month—if the rupee depreciates by more than this, and it has many times more, speculation is still profitable.
If it helps, keeping communication lines straight is also something that figures prominently in the FOMC minutes released late Wednesday. Since markets have been confused by Fed Chairman Bernanke’s statements on when he would begin the taper, FOMC participants discussed how best to communicate the taper schedule with the market, or the indicators to watch for—unemployment, housing starts, whatever—to see where the Fed would go. So far, there is little in the minutes to suggest the Fed won’t start with a $5bn cut in monthly bond purchases from September. The actual impact will depend on what the Fed says in its September 18 meeting. If the $5bn is mainly concentrated on US Treasury and not on the mortgage-backed securities, this could be construed to mean the Fed’s approach will be dovish to begin with as housing markets still aren’t robust enough. While the pace of withdrawal will be important for countries like India, the larger point is that compression of the CAD—if you accept the FM’s lower $70bn estimate—won’t be enough to save the rupee. You need high capital flows. Between FY09 and FY12, for instance, though India’s CAD worsened from 2.3% of GDP to 4.2%, strong FDI and FII flows ensured the rupee depreciated from just 46 to the dollar to 48.1. In contrast, while the CAD, to use the numbers put out by the FM, is projected to improve from 4.8% of GDP in FY13 to 3.7% in FY14, the rupee has weakened from an average of 54 to the dollar in FY13 to 64.8 on Thursday. Which is why the FM spoke of $9.1bn of FDI in Q1 and the money to be raised by PSUs. Projecting old data, the Q1 FDI for instance, is a bad idea since the FII outflows based on this metric would cancel out a large part of the FDI inflows. The falling rupee can’t really be fixed till structural issues like CAD are addressed, but a high interest rate regime can’t stem the rupee’s fall either, while it has the potential to considerably damage growth.