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Dealing with the 'crisis'

While the RBI's response to the recent rupee depreciation is surprising to many, it's the consumer behaviour that needs to change

Dealing with the 'crisis'

Normally, an interest-rate hike is a big negative for equity markets, so why did the markets react so surprisingly to the RBI's (surprising) refusal to raise interest rates? But let's start at the beginning. There's this principle called the impossible trinity, which says that you cannot allow free capital flows (India has partially freed capital flows), an independent monetary policy (which India is moving towards, with a clear inflation-targeting mandate given to a relatively 'independent' Monetary Policy Committee) and keep your exchange rate under control.

So keeping this textbook economics in mind, the MPC said like a sarkari babu that its given mandate is to keep inflation under control and that has been behaving. And since managing the rupee (levels) is not its job, there's a market to take care of that.

Now, that has not been the historical image of the RBI. In fact, the public has always counted on the RBI to 'rescue' them by reading the tea leaves to figure out their 'comfort'. Just last year, the rupee was pushed to the wall by Donald Trump's weak-dollar insistence, when he threatened to put India under surveillance for being a 'currency manipulator'. The RBI found it difficult to absorb all the $20 billion that came in during January-March 2017 and had to let the rupee appreciate. It stayed that way for precisely a year. That resulted in a massive over-appreciation of the rupee, almost 20 per cent to its real effective exchange rate.

Then came the current 'oil-price shock'. In percentage terms, it qualifies to be called a shock, approaching about 40-45 per cent uptick and threatening to go up to 70 per cent at the peak of $100. And India loses $1.2 billion for every dollar that oil go ups - that's $18 billion extra per annum over the last year's outgo. This has pushed up India's current account deficit to an expected 2.8 per cent of GDP, not fun.

The dollar has appreciated 14 per cent so far, well above the 8 per cent it should have done (two years' inflation of 4 per cent each, counted from 68, works out to 73.44, somewhat the current level). But currency markets are feeling the pain, spoiled by the excess flows of 2017, and used to the overvaluation of the rupee.

At a time of generally tighter money, the Indian markets are throwing a tantrum. So far, they have been used to looking to the RBI to save them, like Raghuram Rajan came in last time with his FCNR bonds. The talk was all about 'defending the rupee' and looking to the RBI to 'save them'.

But imports are just around 20 per cent of GDP and interest rates are a blunt tool that will affect the entire country. Why increase interest rates and slow down all investment activity (and levered consumption, such as it is), especially at a time when liquidity and trust are suffering in the aftermath of the IL&FS blowout? Besides, overall inflation is pretty benign (thanks to lower fruit and vegetable prices, an odd contributor), especially in an election year, when growth is important to spruce up the government's report card. Besides, it simply was not the RBIs' job (as per its mandate), even though it had the image of being the protector of the rupee value. So free capital flows should now take care of the rupee's value, since inflation had been protected by the RBI. Since the country had taken care of its fundamentals (and the government did its bit by keeping the fiscal deficit under control), the rupee would find suitors on its own, either through its exporters or through capital flows. Right?

We don't know. In the short term, the markets threw a real tantrum as if they had been deserted by the RBI. And they have threatened to jump out of the window if Mommy does not pay attention. The threat is of an FII pullout (do FIIs panic like our retail investors?) and sheer panic, since RBI seems comfortable with the current levels of the RBI.

That's not really true. Very rarely, but the RBI indicated a 'comfortable' level of `72.50 and most banks have indicated a range of 69-73 for the rupee. So what's cooking? Who is going to win this 'tantrum battle'. Will Mommy call the bluff of the recalcitrant kid, or will the kid really jump off the windowsill?

In dispute is the role of the RBI and, rarely, whether the government should play Mommy to the markets. If unnecessary imports are the problem (and a lot of that might include fuel oil, not just the old suspects like gold, electronics, etc.), then you should clamp down on those through customs duty. Why should 20 per cent of the economy (the importing economy) hold up the entire economy and demand that we increase rates to bring in capital flows, which by the way, somebody has to pay.

For a long time, the government held its nerves, passing through the price signals coming from the oil market that demand is overheating through global growth and inventories are reducing. This demands a change of behaviour from the people who are consuming too much. In a world with lots of alternate (energy) options, I don't know why we must stick to old habits and then crib about paying for them. If you want to still run that big SUV and don't take the Metro (or better, shift permanently to an EV), then don't blame Modi for it.

Like in all economics, there's a reward for good behaviour and a punishment for bad behaviour. Good behaviour, in the current context, would be to shift to the Metro, save on your oil bill and buy the market at 10,300. Bad behaviour would be to pay through your nose at the petrol pump, lose your savings and therefore sell the Nifty to 10,300 in order to fund the oil bill. Take your pick, which part of the economy do you want to be in?

Previous governments used to distort the message that the (oil) markets were giving. The government would rush to protect its spoilt child - the Indian middle and corporate classes - and subsidise their oil bill from its own kitty, and push up general inflation through the expansion of its own fiscal deficit. It's important that this government has not done any such thing, retaining the Modi image for doing the right thing in the face of political odds.

So then why did the Modi government lighten the message to masses by reducing the excise duty? Ah well, nobody's perfect, especially in an election year. But remember, it's temporary and could come back after the elections. Be prepared, high oil prices are not going down unless there's a structural shift of energy demand out of oil. Unlike previous cycles, Big Oil is not fooled into investing into new capacity this time, only to see oil prices go through the floor by the time the oilfield comes up. You will only see marginal and balancing investments, and of course, shale will invest in shorter gestation projects. But the most likely cause of the next crack in the oil market will be a pronounced shift to electric vehicles, which will be faster than you can imagine.

Without knowing this, I shifted last year out of my car and tried to make do with Delhi's public transport - just an experiment to see whether it affected my productivity. Amazingly, it improved my productivity. The new DTC buses are amazing. I get reading and YouTube time, no traffic hassles, and at 1 per cent of the cost of running my car. Try it. The whole of Europe is going the same way!

The author teaches, trades and writes at spandiya.blogspot.com.