Dr. Feelgood.... Raghu's Reality check

Hi All,

An interesting read from economist.com

http://www.economist.com/blogs/banyan/2013/09/india-raises-interest-rates

Raghu's reality check

ONE of my favourite Economist covers is “A Week on the Wild Side” from the Wall Street crash of 1987. A cartoon by Kal, it depicts a mob of frantic traders who in a few minutes shift from panic to wild euphoria. Time does not move quite that fast in India but the country’s financial markets have experienced a full cycle in the past three weeks, swinging from terror to joy. The surprise interest rate rise today, September 20th, by the Reserve Bank of India (RBI) should shift the mood back to realism and return attention to India’s inflation problem. Raghuram Rajan took over as the RBI’s boss on September 4th and was immediately christened “Dr Feelgood” by one newspaper. His medicine may not feel quite so good now but is in India’s long term interest. It is also a reminder that emerging economies’ battle to contain inflation and stabilise their currencies is not over.

First, a re-cap on that rollercoaster ride. At the end of August, India was in a state of despair and facing its worst economic spot since the crisis in 1991. The rupee was tumbling. Then on his first day on the job Mr Rajan made a bullish speech that calmed nerves. A favourable sequence of events then followed. The prospect of military action by America in Syria receded, sending the oil price down by about $5 a barrel, which makes life easier for India, a big energy importer. Two of India’s best known corporate chiefs, Deepak Parekh of HDFC, and Aditya Puri of HDFC Bank, a related lender, both predicted the worst was over. Mr Puri declared growth would return quickly to over 7%, from the present 4.4%.

And then in the greatest gift of all on September 18th the Federal Reserve blinked and said that it would not “taper” its vast purchases of bonds but instead keep policy ultra-loose. In an example of how the world has turned upside down that was greeted with a modest reaction on Wall Street but euphoria in emerging markets, particularly those such as Indonesia and India that had been hit hard by the sell-off since May, when the Fed said it might slow its bond purchases. All of this had a powerful effect, with India’s stock market up by 12% since the end of August and the rupee up by 11% from its all-time low of 68.8 per dollar, hit on August 28th.

Mr Rajan’s statement today may inject some realism back into the debate. First, he has reminded everyone that “the postponement of tapering is only that, a postponement”. Most economists think that by December the Fed will start to wind down its purchases­, just as India’s general election campaign begins to ramp up. That could mean another round of disruption in the foreign-exchange markets. Reflecting the bounce in the rupee Mr Rajan did ease some of the emergency liquidity tightening measures put in place in July to bolster the currency, boosting short-term market interest rates. But he has kept open the option of tightening again if the market has another wobble. He will also be watching closely the RBI’s efforts to persuade banks to raise more dollar deposits and swap them into rupees at a subsidised rate. This increases the flow of money into India. So far this programme has raised about $1.4 billion, a drop in the ocean compared with India’s total financing needs of $250 billion over the next year (including re-financing of short-term debt). But it is early days. 

The second dose of realism regards the economy. Mr Rajan has said that there are few signs of a recovery. As well as the slump in industry and infrastructure, the RBI notes that consumption “is starting to weaken even in rural areas”. At the same time inflation remains too high and may rise further. He again emphasised consumer prices, which are rising at about 10%, as opposed to the traditional wholesale price measure, which is running at a less alarming 6%, although it is on a rising trend. The impact of a weaker rupee has yet to fully feed through and may raise inflation higher still. Reflecting all this, he raised the policy interest rate by a quarter of a percentage point to 7.25%. As long as the emergency liquidity measures are in place the practical relevance of this policy rate is limited (the effective overnight interest rate in the market is now nearer to 9.5%, down from 10.25%). But if and when those emergency measures are withdrawn Mr Rajan wants to make sure that underlying policy is tighter.

The reaction in India’s markets has been negative, with both the stock market and rupee falling. Inside the government the response may be worse—hopes that Mr Rajan would stoke the economy ahead of the election have been dented. But he is doing the right thing by reminding India that the world is still an unpredictable place, that its economic troubles are not over, and that the battle against inflation is not yet won.