By: Punam Sharma
Market is aflutter since Rajan unveiled his intention not to continue beyond September as Governor of RBI. The timing, as well as the method of announcement, comes as a surprise to most participants insofar that perhaps there is a suggestion of less than full co-ordination and agreement between various policymakers. The letter seems to suggest that Rajan was amenable for a renewal but ‘on due reflection, and after consultation with the government’, decided to move on nevertheless. This in turn has naturally given rise to speculation whether the government would want a conduct of looser policy from the next Governor.
We analyze below this development in greater detail.
The timing of this transition is definitely less than desirable. There are near term headwinds to global risk-taking (Brexit vote this week) as well as to rupee in particular (Iran payments over 3 months and FCNR redemption between September – November). It must be remembered that currency fluctuation accounts for a large part of bond market decision making for offshore investors. The current mix of RBI and government policies have been deemed prudent by investors and has helped make the rupee a ‘low beta’ play amongst most emerging markets (EMs). This has improved the attractiveness of Indian financial assets to offshore investors, most particularly bond investors. The current transition perhaps makes the rupee on the margin more susceptible to episodes of global risk off. Thus if Britain’s vote and other episodic triggers create tailwinds to global risk- taking, then the transition may be looked at benignly. However if risk off were to take hold again then India may require compensatory tailwinds of its own (GST, growth green-shoots, other policy measures) to preserve the low beta status of the rupee.
Potential reaction function of the new Governor
A large part of the current criticism of Rajan seems to rest on the argument that he has kept rates too high while focusing on CPI, which rates cannot influence anyway. A vital point that gets forgotten in this argument is that it is the government that has given a signed mandate to the RBI to pursue a 4+/-2% target on CPI. Also this mandate has contributed significantly in preserving rupee as a low beta EM currency and attracting foreign capital flows. So if the government of the day did not want ‘high interest rates’ then it could have easily have set a different mandate for the RBI. Interest rates would then have been lower. However, the volatility associated with Indian assets would correspondingly have been higher as well. Arguments around CPI being a faulty target generally conveniently focus only on the merits of lower rates locally without bothering to acknowledge the benign rub-offs that CPI targeting has had on the flow of global risk capital into India; particularly in fixed income.
However, the immediate point about bringing to light the CPI targeting mandate is to also examine how a new Governor with (presumably) a more dovish disposition may be able to bring policy rates materially lower. In our view it can happen as follows:
a. A more liberal interpretation of the 4+/-2% target: Under the current regime, the RBI is focusing on 5% CPI by March 2017 and then 4% a year later (although the latter has looked like wishful thinking for some time now). Focusing on the mid-point of the band makes the target band longer term sustainable by purchasing some buffers against episodic inflation. However, the new Governor could focus only on the upper band and hence find room to cut rates further. He/she could also potentially focus more on ‘opportunistic windows’ for cutting, giving weight more to cyclical or episodic factors rather than structural themes.
b. A re-work of the CPI target: There are enough influential voices in current policy circles who argue for a re-work of the mandate, and include other measures like WPI and / or put greater weight to growth. This would then throw up a whole new paradigm for potential future policy reaction functions. However, it would be extremely negative messaging for offshore investors who will most likely take this as moving back in policy evolution.
Either way if a new Governor is perceived to be diluting the current CPI targeting regime, it is likely that offshore bond investors will start to look at India in a more tactical fashion than is the case currently.
The announcement of this transition at RBI, on the margin, challenges the hitherto underlying paradigm of Indian bonds; that of low price volatility. This has especially been true since RBI unveiled the new liquidity stance in its April policy. However, more generally and especially in the eyes of offshore investors, Indian bonds have enjoyed the benign intersection of prudent RBI and government policies. If the RBI were to transition into a more ‘CPI tolerant’ central bank, then on the margin one pillar supporting lower volatility in both currency and bonds would weaken. This will get most visible during episodes of global risk-off, whereas periods of benign global risk will tend to mask this fact. Also, at some juncture local market participants may start to look forward to extra monetary easing that the new Governor may bring about. However, while we will try and be alive to this possibility, we think it is premature to already align to this view; for at least 3 reasons: One, the first full policy of the new Governor will come in the thick of FCNR outflows. It is hence likely that he/she waits out this period before deciding on further rate cuts. In this case the first real ‘window’ may then be towards calendar year end. Two, if average CPI continues to trend higher possibly on the back of the much anticipated post monsoon disinflation underwhelming and / or rupee starting to weaken meaningfully, then even incremental rate cuts may lose their potency to influence bond yields meaningfully and will in fact lead to further curve steepening. Three, if incremental easing is done largely through liquidity measures like CRR (a measure that the current Governor has resisted so far), this also would be a trigger for further curve steepening in which long duration will continue to underperform. Given all of this, we reiterate our view of 1 – 5 year rates offering the best risk-reward.
Of course it is equally possible that the government is well aware of the need to maintain continuity and that the new Governor doesn’t lead to any meaningful changes to the RBI’s reaction function. The new committee based approach to decision making may further cement continuity. In such an event, there may be no reason to revisit the current paradigm at all.