Special Report: Building an India Resistant to Currency Shocks and Inflation by William Ortel.
Inflation, currency shocks, and their unequal impact on the Indian population as a whole have been brought up repeatedly in this week’s coverage of India.
In part one of a two-part interview with Pradip Shah, the founding managing director of Crisil, and a board member at several India-based companies.
In this first section of our interview, we discuss how India has recovered from currency shocks, how it might recover further, and the progress of various initiatives that have been undertaken to mitigate the impact of those factors on India’s vast population living in poverty. Subscribe to ensure you don’t miss part two, and consider attending the India Investment conference if your schedule accommodates.
CFA Institute: Pradip, India is perhaps unique in that it’s a country that’s raising rates to try and to control inflation. From where I’m sitting in New York, and maybe from where the Fed governors are sitting across the country, some inflation would be OK for us as long as it got us some growth. How do you see the growth-inflation trade-off in India? Is it the same sort of consideration?
Pradip Shah: At this time, there is certainly a trade off. They are addressing inflation in a manner that is depressing growth because the Reserve Bank of India has taken on all the burden of fighting inflation, through tight money and dear monetary policy.
As a consequence, because of high interest rates, we’ve seen a slow down of big ticket purchases by consumers, such as housing, or consumer durables or automobiles, and so on.
Not only that, tight monetary policy has discouraged investment. We had, at one time I think, 38 percent of the GDP in Investment, which has probably fallen well below 30 percent now. That’s not good for an economy which needs a lot of infrastructure development and possesses a lot of investment possibility.
We have population growth; we have an underserved population with infrastructure being very poor, whether it’s public transport, roads, whether it’s irrigation of water for both urban as well as rural, and so on. There are a lot of investments that can take place, but it does get inhibited by higher interest rates.
One of the things that you mentioned is that, the central bank sort of sees its role as being the guardian of the purchasing power of the currency. There’s been some volatility in the rupee to say the least. How should we been looking at that?
Firstly, there was a catch up provision in the rupee depreciation. Between 1991, when we had the big bang of reforms, and 2001, the Indian currency depreciated by about 4.6 percent per year. The 10 years thereafter it depreciated only by about 2.6 per year. If you even extend it to early August, the depreciation was about 2.7 percent.
Now, 2.7 percent per year is less than the interest rate differential. There is an inflation differential between the dollar economy, and the Indian rupee economy. There was a catch up. For instance, look at August 2011, just a little over two years ago: the rupee appreciated to about 38 rupees to the dollar, it clearly went the other way. All on the back of financial flows, and a thin currency market.
Now, it went the other way at 68 rupees. When suddenly there was a lack of confidence triggered by the main announcement by Bernanke that they would begin to Taper QE3. Then many people started looking at all emerging markets in a different light. That caused a currency flight until the reserve bank got into the act.
In the mean time, some of us had been screaming for import duties. Import duties were introduced on gold, which took away 60 million dollars of currency when Individuals purchased gold.
The highest amount of gold purchases came about last year, in terms of gold being bought as ETFs, gold bouillon, bar form, non jewelry gold. This is clearly intended a store of value. People were shifting to gold, because of the inflation.
We were arguing for import duties. Duties helped bring about current deficit reduction, but, in addition, the reserve bank took three very interesting steps which were very useful.
Firstly, they took off 144 billion dollars of annual import demand of oil from the currency market. That dollar demand, 12 billion dollars a month, was far greater than the current account deficit. It tilted the currency market in favor of the rupee.
Secondly, the Reserve Bank of India entered into swap arrangements with other countries. For example, it entered into a 50 billion dollar swap with the Japanese government. That’s like having the Japanese government back us with 50 billion dollars in case of emergency. Of course, like reciprocity demanded, we will do the same if Japan got into a crisis. Fortunately, this worked for us, just not very well. It gave confidence, that there was money backing the reserve that the reserve bank already had.
Thirdly, the reserve bank opened up the foreign currency non-resident tap.
Again, I had argued for it in a meeting with the finance governor in June, July I wrote an article along those lines. But that governor changed and Raghuram Rajan came in, but that earlier governor announced that, Yes, we’ll open up the reserve. Exactly as I suggested.
They gave an incentive to banks to tap into the network that they already had in the Middle East, places where the Indian Diaspora exist in large numbers. The idea was to give the banks a little incentive by setting off liabilities and limits on foreign currency deposits.
The governor, currently, Raghuram Rajan did one better. He said to the banks, “Go out, raise money from non-resident Indians by way of foreign currency non-resident deposits, and you can swap that into rupees for 3.5 percent cost per year.” Now, that was very attractive. Given the current low interest rate environment in dollars worldwide, we’ve got banks that are able to borrow money at about five percent.
They have 3.5 percent hedge cost, and the banks have an all in rupee cost at 8.5 percent, which they can easily lend out for two or three percent more than that. There’s a very attractive window that’s been created which brought in 10 billion dollars in one month’s time. By November 30th when it ends, it will bring at least another 10 billion dollars. The reserve bank has realized that it can open the tap.
More importantly, this signals to the market that it should not take rupee depreciation for granted. We have tools in our armory to address very sudden or spiky depreciation. Rupee depreciation hurts us. It adds to inflation.
It fuels inflation because we import 70 percent of our oil. That’s very important, because oil is needed to move the economy. Think about everything we do with diesel: from things as simple as bringing vegetables home to more complex things.
If diesel goes up in price, of course, your inflation increases. Our whole motto, our whole objective is to control inflation. We can’t allow the rupee to slide without concern. We will monitor it. The reverse bank still articulates that they don’t have a target rupee dollar rate in mind, but they’ve said that if it is seen to be excessive, they will control it.
They’ve brought it to around 61.5 to 62 rupees to the dollar. The government would have ideally liked it at 60. The finance minister went on record, which perhaps did a little bit of a job on the market, saying that the rupee should have been at 58 rupees to the dollar. That’s a fair rate. Perhaps at 60 or 61 rupee, it would seem that the rupee has caught up with the inflation differential, and this reflects a true value in purchasing power parity.
Unless we have a currency pull out or investment leaving or entering India in uncontrolled quantities, we should see an orderly currency movement. That’s in respect to investment, again, of course. If the rupee seems to be relatively stable, if we didn’t have a current account deficit, that would be wonderful. That would have been a blessing.
But we still have a current account deficit. Having controlled the gold import, we think the current account deficit will come down to about three, 3.5 percent, from what we had at 6 percent at one time.
Well, there are two things that I really want to pick up on there. The first that you alluded to is sort of the power of the Indian diaspora, which I think is something that is difficult to appreciate for those of us who may not be as familiar.
Can you just sort of touch on this notion that, because of emigration trends that you’ve seen as a country