Damned If You Do(n’t) : The Unusual Tantrum On Freak Friday



Normally, an interest rate hike is a big negative for equity markets, so why did the markets react so surprisingly to the RBI’s (surprising) refusal to move on interest rates?
Declaimer: This article was originally in December 2018, and some of the data points may be outdated

But let’s start at the beginning. There’s this principle called the Impossible Trinity: that you cannot bake your cake, have it, and eat it too….. there’s a tautological impossibility that defies an almost physical law. So you cannot allow free Capital Flows (India has partially freed Capital flows), have an independent Monetary Policy (which India is moving towards, with a clear inflation-targeting mandate given to a relatively ‘independent’ Monetary Policy Committee), AND keep your exchange rate under control.

So keeping this textbook Economics in mind, the MPC said like a sarkari babu, that their given mandate is to keep inflation under control, and that has been behaving. And since managing the Re (levels) is not their job, there’s a market to take care of that.

The historical Image of the RBI

Now, that has not been the historical image of the RBI. The public has always counted on the RBI to ‘rescue’ them, reading the tea leaves to figure out their ‘comfort’. It’s been a good idea when (rarely) the Re appreciates, this is important because it is very recent. Just last year, the Re was pushed to the wall by Donald Trump’s weak Dollar insistence, when he threatened to put India under surveillance for being a ‘currency manipulator’. The RBI found it difficult to absorb all the $20 bn that came in during Jan-March, 2017, and had to let the Re appreciate. It stayed that way for precisely a year. That resulted in a massive over-appreciation of the Re, almost 20% to its REER.

Then came the current ‘oil price shock’. In percentage terms, it qualifies to be called a shock, approaching about a 40-45% uptick, and threatening to go up to 70% at the peak of $100, if that is achieved. And India loses $1.2 bn for every $ that oil goes up, that’s $18 bn extra per annum, over last year’s outgo. This has pushed up India’s CAD to an expected 2.8% of GDP, not fun.

The Dollar has appreciated 14% so far, well above the 8% it should have done (2 years’ inflation of 4% each, counted from 68, works out to 73.44, somewhat the current level). But currency markets are feeling the pain, spoiled by the excess flows of 2017, and used to the overvaluation of the Re.

The Indian Market

At a time of generally tighter money, the Indian markets are throwing a tantrum. So far, they have been used to looking to the RBI to save them, as Raghuram Rajan came in last time with his FCNR Bonds. The talk was all about ‘defending the Re’ and looking to the RBI to ‘save them’.

But imports are just around 20% of GDP, and Interest Rates are a blunt tool that will affect the entire country. Why increase Interest Rates and slow down ALL investment activity (and levered consumption, such as it is), especially at a time when liquidity and trust are suffering in the aftermath of the IL&FS blowout? Besides, overall inflation is pretty benign (thanks to lower fruit and vegetable prices, an odd contributor). Especially in an election year, when growth is important to spruce up the Government’s report card. Besides, it simply was not the RBI’s job (as per its mandate), even though it had the image of being the protector of the Re value.

So free capital flows should now take care of the Re’s value since inflation had been protected by the RBI. Since the country had taken care of its fundamentals (and the government did its bit by keeping the Fisc under control), the Re would find suitors on its own, either through its exporters or through capital flows. Right?

We don’t know. In the short term, the markets threw a real tantrum, as if they had been deserted by the RBI. And they have threatened to jump out of the window if Mommy does not pay attention. The threat is of an FII pullout (do FIIs panic like our retail investors?) and sheer panic since RBI seems comfortable with the current levels of the RBI.

That’s not true. Very rarely, but the RBI indicated a ‘comfortable level’ of Rs.72.50, and most banks have indicated a range of 69-73 for the Re. So what’s cooking? Who is going to win this ‘tantrum battle’? Will Mommy call the bluff of the recalcitrant kid, or will the kid jump off the window sill?

The Role Of The RBI

In dispute is the role of the RBI, and rarely, whether the government should play Mommy to the markets. If unnecessary imports are the problem (and a lot of that might include fuel oil, not just the old suspects like gold, electronics, etc), then you should clamp down on those through Customs Duty. Why should 20% of the economy (the importing economy) hold up the entire economy? And demand that we increase Rates to bring in capital flows, which by the way, somebody has to pay.

For a long time, the government held its nerves, passing through the price signals coming from the Oil market, that demand is overheating through global growth and inventories are reducing. This demands a change of behavior from the people who are consuming too much. In a world with lots of alternate (energy) options, I don’t know why we must stick to old habits, and then crib about paying for them…..if you want to still run that big SUV and take the Metro (or better, shift permanently to an EV), then don’t blame Modi for it.

Like in all Economics, there’s a reward for good behavior and a punishment for bad behavior. Good behavior, in the current context, would be to shift to the Metro, save on your oil bill, and buy the market at 10,300. Bad behavior would be to pay through your nose at the petrol pump, lose your savings, and therefore sell the Nifty to 10,300 to fund the oil bill. Take your pick, which part of the economy do you want to be in?

Previous governments used to distort the message that the (oil) markets were giving. The government would rush to protect its spoilt child, the Indian middle and corporate classes, subsidize their oil bill from its kitty and push up general inflation through the expansion of its own Fiscal Deficit. It’s important that this government has not done any such thing. Retaining the Modi image for doing the right thing, in the face of political odds.

So then why did the Modi government lighten the message to the masses, by reducing the Excise Duty?! Ah well, nobody’s perfect, especially in an election year. But remember, it’s temporary and could come back after the elections. Be prepared, high oil prices are not going down unless there’s a structural shift of energy demand out of oil. Unlike previous cycles, Big Oil is not fooled into investing in new capacity this time, only to see oil prices go through the floor by the time the oilfield comes up. You will only see marginal and balancing investments, and of course, shale will invest in shorter gestation projects. But the most likely cause of the next crack in the oil market will be a pronounced shift to Electric Vehicles (EVs), which will be faster than you can imagine.

Without knowing this, I shifted last year out of my car and tried to make do with Delhi’s public transport. Just an experiment, to see whether it affected my productivity. Amazingly, it improved my productivity, the new DTC buses are amazing, I get reading and YouTube time, no traffic hassles, and at 1% of the cost of running my car. Try it….the whole of Europe is going the same way!!!



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