X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Interest rates - time to change course - Outside View by S.S. TARAPORE
  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

Interest rates - time to change course
Dec 28, 2015

We can't ask for both a strong Rupee and low interest rates, without risking massive outflows of portfolio investments

At long last the US Fed has undertaken a predictable lift-off of its rates from 0-0.25 per cent to 0.25-0.5 per cent. The Fed had prepared markets and there was hardly a ripple in exchange and financial markets. Whatever be the number of Fed increases in 2016, it is clear that there is a directional shift in Fed monetary policy. Sooner or later there would be outflows of portfolio capital from emerging market economies (EMEs).

The Indian authorities claim that that they are well prepared to face the changing international financial environment. Nonetheless, we need to ensure that exchange rate and monetary policies are in sync.

Both, official and public preoccupation is with the US dollar-rupee rate and there are screaming media headlines such as “Rupee breaches 67”. What matters is the real exchange rate, that is, the nominal exchange rate adjusted for inflation rate differentials.

Till 1997, the Reserve Bank of India (RBI) used as a pole star the Real Effective Exchange Rate (REER), that is, a trade-weighted nominal exchange rate adjusted for inflation rate differentials. Initially, two models were used, namely, a 5-country model and a 36-country model.

But after 1997, the RBI was somewhat disenchanted with the REER on the ground that the trade weights do not take cognisance of services, and shifting the base year gives varying results. Thus, the RBI shifted its emphasis from the REER to ‘control of volatility'. While control of volatility is desirable, it does not make for a comprehensive exchange rate policy.

The RBI does, however, continue to publish the REER based on 6-country and 36-country models. The October 2015 REER shows an appreciation of 10 per cent on the 6-country model and 24 per cent on the 36-country model. Again, a simple adjustment of the nominal US dollar-rupee exchange rate for inflation rate differentials would point to the need for a competitive exchange rate of around $1= Rs. 71-72.

Depreciation of EMEs

Since January 1, 2015, the depreciation vis-a-vis the US dollar has been: Brazil (45 per cent), South Africa (33 per cent), Russia (23 per cent) Mexico (18 per cent), Korea (8 per cent) and India (6 per cent).

The RBI has developed skills in dealing in the spot and forward markets, and more recently has been testing the waters in futures, options and non-deliverable forward markets. Central banks always face the danger of speculators trying to ‘break the bank' if the central bank is too open about its exchange rate strategy.

Intervention is a tricky operation and a central bank needs to be sure that it is fighting speculation and not a fundamental disequilibrium. Once a central bank is sure about its assessment it should hold its nerve and confidently intervene in the forward market to crush speculation. This is easier said than done. At the present juncture, there are many indicators pointing to the rupee being overvalued.

Indian exports, particularly micro, small and medium, are clearly on a decline, and imported goods are swamping Indian domestic markets. In the ensuing period, the RBI would do well to hold its powder dry and intervene to stop a depreciation of the rupee only after it is totally sure that markets have depreciated the rupee excessively.

China's exchange rate index

China has set up a new 13-country exchange rate index. The RBI should undertake an indepth study on the construction of this index. The US dollar has a weight of 26.4 per cent in the Chinese index while in the SDR the dollar has a weight of 41.7 per cent. Some analysts claim that the Chinese yuan is overvalued by 14 per cent and there is a strong possibility of a large outflow of portfolio capital. When the yuan depreciates against the dollar it will put pressure on the Indian rupee.

Hardly had the dust settled on the US Fed rate hike when there was a clamour that Indian interest rates should be lowered. With the progressive increase in the US Fed funds rate, it would be sheer harakiri to reduce RBI policy interest rates. The RBI should not remain accommodative. It should be made clear that we have reached the end of the interest rate reduction cycle.

With the regulations on marginal costing coming into effect from April 2016, if the authorities persist with policy interest rate reductions, deposit interest rates will fall precipitously and adversely impinge on total savings and growth. It is in this context that the RBI's February 2016 policy announcement would be crucial.

Clear choices

The choices are clear. If we wish to have a strong rupee and low interest rates, we should be prepared to have a massive outflow of portfolio capital. This will call for severe measures on both the rupee exchange rate and monetary policy. The more sensible course would be to allow a gradual depreciation of the rupee and calibrated increases in policy interest rates which would minimise the portfolio capital outflow.

Tailpiece: The excellent mid-year Economic Review of the ministry of finance suggests a lower GDP growth rate of 7.0-7.5 per cent as against 8.1-8.5 per cent hitherto. The review, however, hints at the need for lower interest rates, a less rigorous target for reduction of inflation and also postponing the fiscal correction target.

While this may appear to be imperative from the need to stimulate growth, it also implies a resurgence of inflation and a depreciation of the rupee. These signals are worrisome as it ultimately will lead to policy inconsistencies resulting in a weaker macroeconomic performance and greater suffering for the masses.

The Centre should take a hard look at these implications.

Please Note: This article was first published in The Hindu Business Line on December 25, 2015.

This column, Maverick View is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Freepress Journal, is titled Common Voice.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

Equitymaster requests your view! Post a comment on "Interest rates - time to change course". Click here!

  

More Views on News

How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

Jun 10, 2017

Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

Why NOW Is the WORST Time for Index Investing (The 5 Minute Wrapup)

Aug 18, 2017

Buying the index now will hardly help make money in stocks even in ten years.

Trump Takes a Beating (Vivek Kaul's Diary)

Aug 18, 2017

Donald J Trump, a wrasslin' fan, took a 'Holy Sh*t!' blow on Tuesday.

How To Read Your Mutual Fund Account Statement Correctly (Outside View)

Aug 17, 2017

PersonalFN simplifies the mutual fund account statement for you.

This Small Cap Can Drive Chinese Players Out of India (and Make a Fortune in the Process) (The 5 Minute Wrapup)

Aug 17, 2017

A small-cap Indian company with high-return potential and blue-chip-like stability is set to supplant the Chinese players in this niche segment.

More Views on News

Most Popular

Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

Aug 7, 2017

The data tells us quite a different story from the one the government is trying to project.

A 'Backdoor' to Multibaggers: It's Like Investing in Asian Paints Ten Years Ago(The 5 Minute Wrapup)

Aug 10, 2017

Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.

Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

Aug 8, 2017

Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

Signs of Life in the India VIX(Daily Profit Hunter)

Aug 12, 2017

The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

Aug 7, 2017

Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

More

Become A Smarter Investor In
Just 5 Minutes

Multibagger Stocks Guide 2017
Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

S&P BSE SENSEX


Aug 18, 2017 (Close)

MARKET STATS