India may be forced to tighten monetary policy as it faces financial crisis

As emerging markets including India tank with the rupee hitting record lows against the pound and the dollar, Shweta Singh of Lombard Street Research suggests that expectations of quantitative easing withdrawal are now "baked in".

It now looks as if Raghuram Rajan will have a tough start at India's central bank (a stark contrast to the fortunate timing of Mark Carney's arrival at Threadneedle Street in the UK).

(i) Quantitative tightening – The first tranche of quantitative tightening steps were announced on 15th July, followed by additional measures on 23rd July. There was a sharp jump in both short term rates and longer dated yields. We had emphasized that quantitative tightening, whilst not effective in the medium term, may offer some stability to INR in the short-term by restricting speculation and supporting the debt market. Yet, in the monetary policy meeting on 30th July, the central bank struck a relatively dovish tone, throwing INR into a tizzy.

Late last evening, the Reserve Bank of India (RBI) announced another set of measures in a bid to undo the damage caused by the conflicting policy messages. The aim of the latest set of steps is to keep just short term rates high. The central bank will conduct open market purchases of longer dated government securities to drive down the yields, effectively withdrawing a substantial portion of the quantitative tightening measures put in place earlier.

(ii) Capital account – On the one hand, the government has been taking steps to liberalize foreign investments to fund the current account deficit with the more recent announcements to this effect made on 16th July and 19th August. On the other hand, it imposed restrictions on capital outflows by residents (14th August). This has exacerbated investor sentiments, creating fears that India may resort to the draconian controls on capital outflows (even) on non-residents as were imposed by Malaysia during the 1997-98 crisis.

(iii) Current account – The large current account deficit is one the foremost concerns for the economy. The key contributors to the deficit are oil and gold imports. The former is on account of subsidized fuel prices (in other words, wasteful public spending). Higher gold imports are a reflection of negative real rates courtesy of high inflation. The latter is also largely a consequence of populist fiscal policy. The government hiked the import tax on gold for the third time this year in mid-August, raising it to 10% from 4% in a bid to temper gold imports. Worryingly, whilst trying to temper the symptoms (high gold imports, high current account deficit), the government is in fact, aggravating the causes (wasteful public spending) by pushing for the Food Subsidy Bill as it prepares for the elections due in May next year.

A weak currency hurts India on various fronts: higher subsidy bill (due to an increase in the oil import bill); higher current account deficit (due to sticky imports); higher inflation and higher external debt (80% of external debt is foreign currency denominated). In the absence of a credible policy response, currency weakness and volatility may create a vicious loop.

The ideal response would be to curtail public spending, especially on subsidies. However, this seems increasingly unlikely given the elections next year. An aggressive push on structural reforms may also help. But, these are measures that take time to have an effect and are difficult to implement given the political climate. Authorities may also ease restrictions on foreign investments further, issue sovereign backed dollar denominated bonds, raise interest rates on NRI deposits, and enter into currency swap agreements so as to provide some immediate reprieve to the currency. But, with the limited window of opportunity getting even narrower, the newly appointed central bank governor, Raghuram Rajan, may be forced to tighten aggressively, not the least to avoid a more disruptive tightening by market forces.