RBI should intervene less, let rupee depreciate gradually: D Subbarao

In a Q&A, the former RBI Governor says the situation is very different from the Taper Tantrum and that the rupee has actually risen against some other hard currencies

Amid a recent bout of volatility in the foreign exchange market, former Reserve Bank of India Governor Duvvuri Subbarao told Bhaskar Dutta in an interview that the rupee is tracking fundamentals and that the central bank should let the domestic currency gradually depreciate. While the rupee has recently weakened to new lows to the dollar, the depreciation has been much lower than that seen during previous episodes of volatility such as the Taper Tantrum of 2013 or the Global Financial Crisis of 2008. This is owing to heavy market intervention by the RBI in the form of dollar sales. Edited excerpts:

Q. You were at the helm of the RBI during the Taper Tantrum of 2013. The rupee has been volatile but much more resilient this time around. How are we placed on the external front, especially in the backdrop of aggressive tightening by the US Fed?

A. The rupee has weakened by about 5-6 per cent over the past year against the USD largely on account of capital outflows through the FPI route, but also reflecting a rising current account deficit (CAD). It’s important to note though that even as the rupee has depreciated vis-à-vis the dollar, it has actually strengthened against other hard currencies such as the euro and the yen. In fact, the broader 40 country Real Effective Exchange Rate (REER) as of May was overvalued by about 5 per cent. I believe the rupee is tracking fundamentals and that the RBI should lean towards non-intervention rather than intervention, and allow the rupee to gradually depreciate.

The external sector situation today is quite different from the Taper Tantrum period of 2013. For one, pressure was building up in the exchange rate then, whereas the exchange rate today is tracking fundamentals more closely. Moreover, our macro situation then with year-on-year high fiscal and current account deficits was fragile. Today, there is more credibility on the fiscal front and the expected CAD of over 3 per cent this year will hopefully be a one-off. Most importantly, our foreign exchange reserves at $600 billion inspire confidence that we lacked at that time.

Q. There has been much commentary on whether the RBI was late to respond to inflation risks. What is your take on the Indian monetary policy response in the current environment?

A. The current bout of inflation is driven largely, though not entirely, by supply shocks–the prices of food and fuel in particular. The demand for these products is inelastic, which is to say that people’s consumption of food and fuel does not adjust quickly to price changes. The question is what good is monetary tightening which acts on the demand side by raising the price of money when the demand side pressures are inelastic.

My response to that is that no matter what the drivers of inflation, the first line of defence has to be monetary policy. Because if inflation persists long enough, inflation expectations get unhinged--people can generate higher inflation merely by expecting higher inflation. It is to curb that spiral of expectations that monetary policy has to act even if demand pressures are not the primary culprit behind inflation. Combating inflation in situations like this is of course more of a mind game, and the impact will depend on the credibility of the central bank.

Q. Has there been strain on the central bank’s credibility?

A. It looks like that, but only in hindsight. Let me explain. Inflation has been above the RBI’s target band for the last six months and, even as per RBI’s own estimates, is expected to remain above the target band for the next six months. Questions are therefore being asked like whether the RBI was sleeping at the wheel, whether it went overboard on prioritizing economic recovery over inflation and how costly that might be in macroeconomic terms.

That criticism is unfair. The RBI, like other central banks around the world, is having to act under astonishing uncertainty brought on by rapidly unfolding geopolitical developments. Throw your mind back to early April when the RBI indicated exit from its pandemic driven easy money policy.

The war in Ukraine had been on for weeks by then of course, but even seasoned military experts and experienced diplomats were wrong-footed in predicting its course. It’s unfair to expect central banks to anticipate the future more accurately. The RBI was acting within the universe of knowledge available at that time whereas critics are asking questions with the benefit of hindsight.

Several known unknowns persist – the war in Ukraine and its impact on commodity prices, supply chain disruptions because of lockdowns in China, pace of policy normalization in advanced economies and the chances of a hard landing of the US economy which could have knock on effects around the world.

The RBI’s undivided attention should now be focussed on bringing inflation down to 4%, the centre point of its target band. RBI’s credibility will depend on how quickly and how sustainably that outcome materialises.

Q. Growth-inflation projections stand the risk of constant revisions in such a volatile global environment, but in your view, what would be an appropriate real rate for India?

A. The guidance for this comes from the Fisher equation according to which the real rate is the nominal rate minus inflation. It accounts for the compensation that investors and savers demand for loss of purchasing power on account of inflation.

Which interest rate should be used to determine the RBI’s monetary policy stance in real terms is not clear. Is it the overnight rate, one month or one year rate? The answer to that question is non- trivial.

It’s standard practice though for analysts to look at the real rate in terms of the policy repo rate. The real policy rate can’t be a constant; it’s a moving target depending on where in the business cycle the economy is. It’s clear though that when the economy is in equilibrium – that is growth is close to potential and inflation is at the mean of the target band – the real rate has to be modestly positive – say 1%. This is important because we need to make sure savers get a real return. If not, they will move their savings into riskier assets, and gold, which can have a negative impact on growth and stability.

 Q. Has the RBI’s policy response been rendered more complicated by its current liquidity strategy? The system is in a fairly large surplus even as the tightening cycle has commenced in earnest.

A. It is clear that there is surplus liquidity in the system as evidenced by the amount of about Rs 3.5 trillion that banks are depositing with the RBI on a daily basis. In its June policy statement, the RBI has committed to withdrawal of accommodation in order to catalyse monetary policy transmission and make its rate action prevail.

There are two questions, though, on liquidity management going forward. What does withdrawal of accommodation mean? Is it that the weighted average call rate (WACR) tracks the Standing Deposit Facility (SDF) rate (the lower end of the corridor) as the RBI seems to have indicated in the post policy conference? Is that sufficient given the inflation situation? Shouldn’t the RBI be nudging the WACR higher, more towards the repo rate?

The second, and a related question is about whether RBI will depend only on the SDF route for withdrawal of accommodation or will it also resort to open market operations to withdraw liquidity on a more durable basis.

Q. Monetary policy is being rapidly normalised. At what point would you think it would be necessary for us to prioritise fiscal consolidation?

A. I believe the time to prioritise fiscal consolidation is not in the future, but now. In the last budget, the finance minister opted for a longer and more gradual fiscal consolidation path than the market expected. It’s important to stay on track because our long term prospects of growth and stability hinge on a stable and responsible fiscal regime.

For sure, there have been pressures on the fisc (fiscal deficit) not anticipated at the time of the budget such as steeper oil and commodity prices and the faster than expected policy normalization by advanced economies led by the US. All the cushion that has been built into the budget estimates has been eaten up by higher food and fuel subsidies. It’s not clear whether the cess/duty imposed on production and export of petroleum products last week will fully compensate for the additional outgo on account of cut in fuel taxes. Notwithstanding these pressures, I believe it is important to deliver on the budgeted fiscal deficit target, if necessary by additional taxation or expenditure compression.

Q. Two years after the pandemic first struck, what is your assessment of the degree of damage to economic growth?

A. When we learnt that the economy expanded by 8.7 per cent last fiscal year (2021-22), we drew comfort from the fact that GDP caught up with the pre-pandemic level. While that is true in a mathematical sense, we should note that output is still about 5-6 percentage points below the trend level – that is below what it would have been had there been no pandemic. In that sense, there has been a permanent loss of output, no matter the V-shaped recovery.

Much of the burden of this loss has fallen on the low income segments who have lost their jobs, their incomes and their livelihoods. On the other hand, the well-off have in fact seen their wealth and hence their incomes rise on account of the increase in asset prices owing to the pandemic driven easy money regime. This disparity needs to be curbed and reversed not just because it is morally wrong but also because it is critical for our long term growth. So, as much as we focus on recovery and growth, we should also ensure that the benefits of growth flow to the low income segments.

Q. For more than a decade now, communication to markets has emerged as a central bank tool of immense importance. In situations of immense volatility, however, when markets possibly overshoot, is there a guiding role for central banks to play?

A. One of the big lessons of the Global Financial Crisis (GFC) of 2008/09 is that central bank communication can be an effective policy tool in reassuring markets in the midst of extreme uncertainty.

That said, central banks however face many dilemmas. First, it’s when there is high degree of uncertainty in the financial system that markets want most guidance, and it is precisely when there is uncertainty that central banks are least able to give guidance. Also, central banks face a dilemma about how much to disclose to the markets, when and how. Markets might be spooked by unexpected bad news, especially when they are already on the edge. At the same time, it is incumbent on central banks to let the markets know the true state of affairs so that they can make the necessary adjustments. Deciding on the optimal course is oftentimes a challenge.

The guiding principle for central banks should be to give as clear a guidance as possible and indicate the degree of uncertainty surrounding their guidance. Most importantly, central banks should have the humility to admit to errors when their forecasts or estimates don’t materialise.