Politicisation of Indian monetary policy poses significant risks
It has been two years since India was last a focal point for investor nervousness.
The last bout of market turmoil was in the summer of 2013 when the US Federal Reserve triggered a sharp sell-off in emerging markets (EMs) after announcing its plan to start scaling back, or “tapering”, its programme of quantitative easing (QE).
It is worth recalling that what troubled investors most about India back then, aside from the country’s sizeable current account deficit, was the lack of credibility on the part of the country’s central bank.
As the rupee, India’s currency, fell by a dramatic 22 per cent against the dollar between early April and early August 2013, the Reserve Bank of India (RBI) was at sixes and sevens as to how to shore up the currency and restore confidence in India’s financial markets.
Raghuram Rajan, the highly regarded RBI governor who took the reins of the central bank in September 2013, quickly put an end to the dithering and confusion in Indian monetary policy by making it clear at the outset that his overriding priority was to curb inflation - which then stood at 10 per cent - and stabilise the rupee.
By raising interest rates three times in his first months in office, Rajan quickly established his inflation-fighting credentials and, together with the enthusiasm generated by Narendra Modi’s victory in a parliamentary election in May 2014, was responsible for the dramatic improvement in sentiment towards India.
This makes the government’s draft financial code, published last week, which envisages the creation of an interest rate-setting Monetary Policy Committee (MPC) in which four of the seven members would be appointed by the government, all the more troubling.
All of a sudden, one of the most credible central banks in EMs risks having its monetary policy powers significantly diluted.
While the code is just an initial proposal and could still be amended - suggestions and comments must be submitted by August 8 - it comes at a time when there are increasing doubts about Modi’s ability to push through much-needed labour and product market reforms deemed essential in order to lift India’s growth potential.
Indeed sentiment towards India has cooled of late - although mostly due to a general deterioration in market conditions in developing economies.
The rupee has fallen more than 4 per cent against the dollar since the end of January while Indian equities are barely in positive territory this year.
The “Modi mania” which fuelled last year’s dramatic rally in Indian stocks is now a distant memory.
The two catalysts for the improvement in sentiment - the credibility of Indian monetary policy and the prospect of major fiscal and structural reforms - are being called into question.
The challenge to the RBI’s control over monetary policy is particularly ill-timed given the more fragile sentiment towards India.
Much has been made of the contrast between Turkey’s heavily politicised central bank which has been reluctant to raise rates in the face of an inflation rate that is still more than two percentage points above target and India’s credible and independent monetary guardian.
Although India’s inflation rate is currently two and half percentage points below the RBI’s 8 per cent target, the fall is mostly attributable to the steep decline in oil prices. Indeed inflation has been rising again of late.
The recent rate cuts undertaken by Rajan were received positively by markets mainly because of the inflation-fighting credibility he possesses.
If the code becomes law in its current form, further rate cuts - even if warranted by low oil prices - would risk being perceived as politically motivated given the government’s blocking majority on the MPC.
Just as importantly, the code has been published just as Modi’s government is struggling to implement key economic reforms, particularly in the areas of taxation (in May the government failed to push legislation on introducing a much-needed goods and services (GST) tax through the upper house of parliament) and land allocation.
Still, sentiment towards India remains favourable compared with many other large EMs, such as Brazil, Russia and, most worryingly, China.
At least Indian equities are still in positive territory this year compared with a 6.6 per cent slide in EM shares. The rupee, moreover, has only fallen 0.7 per cent against the dollar in the last two months, compared with sharp falls of 22 per cent and 12 per cent for the Russian rouble and the Brazilian real respectively.
All the more reason, then, for India’s government to refrain from meddling in monetary policy.
Nicholas Spiro is managing director of Spiro Sovereign Strategy