RBI Scrambles to Shield Rupee as Marginal Utility of Blaming Nehru Falls

A version of this article first appeared in The India Cable – a subscribers-only newsletter published by The Wire and Galileo Ideas. You can subscribe to The India Cable by clicking here.

Recently in Parliament, Prime Minister Narendra Modi took a dig at Nehru for blaming the 1953 Korean War for inflation in India. Ironically, his own government would very soon have to start grappling with inflation and blame the Ukraine war for it.

The finance minister is making noises about the effects of the Ukraine war on the economy. The Reserve Bank of India (RBI) governor is blaming it for transmitting to India “seismic waves” of inflation in commodities and oil. The truth is that the seismic waves were building up even before the invasion, but in total denial, the RBI was asserting that India was largely insulated from it. One doesn’t know if this was informed by Modi’s characteristic hubris that he would never find himself in Nehru’s predicament!

But in weeks, things changed dramatically at the RBI. Everyone is still wondering why the central bank made an unscheduled announcement this week, raising the benchmark interest rate and withdrawing substantial liquidity from the banking system. The move stunned the market because only 25 days ago, in its scheduled monetary policy statement, the RBI had decided to continue its “accommodative” policy to support growth by keeping the benchmark repo rate unchanged at 4%. However, within a month the RBI chose to reverse its stand and came down with a sledgehammer to not only raise the repo rate by 40 basis points but also withdraw about Rs 87,500 crore immediately from the banking system by raising the Cash Reserve Ratio (cash banks have to mandatorily keep with RBI ) by half a percent. The twin moves were totally unexpected and sent stock markets into a tailspin.

The question is, why did the RBI change its position so quickly? Simple: the central bank had miscalculated the extent of inflation. The RBI projected consumer price inflation at 5.7% for 2022-23 in its early April statement. However, sources say the monthly inflation number for April due to be announced next week is likely to be 7.5-8%. This is a huge underestimation by the RBI. For 2022-23, the RBI is projecting inflation at 6.3% in Q1, 5.8% in Q2, 5.4% in Q3 and 5.1% in Q4. All these numbers may have to be revised in its scheduled statement early next month.

Till a few months ago, the RBI maintained that its hierarchy of concerns was growth, inflation and financial stability, in that order. Now, it’s reversed. Inflation is the primary problem, and financial stability is somewhat shaky.

Some experts believe that the RBI hurried to raise the repo rate because US bond yields were rising dramatically and were perilously narrowing the gap with Indian government security yields. This could have resulted in a big flight of capital from the Indian market to the relatively safe and high-yielding US bonds, putting the rupee under more pressure. In fact, the RBI has already spent over $25 billion from its reserves to defend the rupee. But for its intervention, the exchange rate may have been near Rs 80 to a dollar. The BJP is known to attach a robust masculinity to a strong rupee, and this attitude goes against rational market principles in times like this.

“Poor and middle-income countries in particular have a lot to lose from sharply higher rates at the Fed, which will tempt away capital and weaken their exchange rates, especially if a global downturn saps demand for their exports at the same time,” a recent article in The Economist notes.

It will be interesting to see how far PM Modi allows the RBI to defend the rupee by expending forex reserves, which are already down over $40 billion from its October 2019 peak of $640 billion. Reserves may go down further as India’s growing current account deficit may not be covered by fresh capital flows. Many economists forecast a negative balance of payments for 2022-23. Some say the desperation to push the LIC IPO could be because the government hopes the infusion of fresh foreign capital will help its depleting forex reserves and serve as a signal that India is attracting foreign investment inspite of bad global financial market conditions”.

The differential between US and Indian government bond yields remains critical. US bond yields of various tenures have nearly doubled. The RBI is feeling the heat and is compelled to raise rates in tandem. The sudden repo rate hike may have been in anticipation of the big 50 basis points increase in the benchmark interest rate by the Federal Reserve the next day. It is said to have given the rupee some breathing room. More anticipated hikes of 50 basis points by the Fed are certain to test the RBI and cause further volatility in the rupee’s exchange rate.

India’s inflation story is still unfolding as the domestic effect of energy prices has not been fully felt. Meanwhile, wheat and edible oil prices are on fire. Wheat procurement was expected to be 44 million tonnes but may be halved, according to experts. The private sector has bought off much of the stock from farmers at prices above MSP. This will certainly lead to higher wheat prices. So food inflation will have to be watched very carefully, and will eat into GDP growth.

Overall, the quarters ahead are likely to have inflation at 7-8% and GDP growth of 4-4.5% for all of 2022-23, barring the first quarter, which gets distorted by the low base of economic activity in April-June 2021 caused by the severe second wave of Covid. The way things are unfolding in the political economy, Modi may have to give Nehru some much-needed rest and start looking within.