ANALYSIS. How rupee, fund outflows twisted the RBI’s arm to hike repo rate

The RBI has been rather slow to react to the tightening liquidity in global financial markets unlike other central banks in emerging Asia.

This has resulted in foreign funds pulling money out of Indian debt, even as they were net buyers in the debt markets of other emerging Asian countries in 2018.

The RBI Governor was vehement in denying that the 25 basis points hike in repo rate was in response to the large foreign portfolio outflows from the Indian bond market, insisting that the monetary action was taken soley on the basis of the CPI number.

Rupee woes

But it is clear that the turbulence in the Indian currency and the bond markets would have played a part in the rate decision.

The rupee has been the worst performing Asian emerging market currency in 2018. While the currency is down 5.86 per cent against the dollar so far this year, only the Philippine peso (5.11 per cent) and Indonesian rupiah (3.37 per cent) have fared as badly as the rupee.

Some Asian currencies, such as the Japanese yen, Thai baht and the Malaysian ringgit, have actually gained against the dollar this year.

The rupee has been battered due to the sharp increase in crude oil prices, which has a direct bearing on the country’s current account deficit. Besides this, sharp foreign portfolio outflows from the bond market have also played havoc with the rupee.

It’s a chicken-and-egg situation as far as the currency strengths and FPI flows go.

Weak currency tends to trigger foreign portfolio outflows, which in turn, impacts the currency.

While rising US bond yields have caused a flight of capital from riskier assets, the outflow from Indian bonds has been the most when compared to the other markets in emerging Asia.

Year-to-date outflow from the Indian bond market has been to the tune of $4.5 billion. Other countries, such as China, South Korea, Thailand and the Philippines, have received net inflows to their debt market so far.

It’s obvious that the RBI’s fixation with inflation has made it rather slow in reacting to changing global events, resulting in the under-performance of the currency and outflows from the debt market.

The Indian central bank should have turned wary as soon as the 10-year US treasury yields began moving up last September. From 2.01 per cent in September 2017, US yields hit a high of 3.12 per cent in May 2018. Last time the US treasury yield hit 3 per cent was in September 2013, following the taper tantrums.

Rising yields in the US have always been accompanied by outflows from riskier assets since the home-country bias makes US investors take money back to US-denominated assets. Central banks of many emerging market economies have been hiking their policy rates to control currency erosion and stem outflows. This seems to have helped, going by the movement of the currencies of these countries.

South Korea was the first off the mark, raising its benchmark interest rate for the first time since 2011 in November last year. The central bank of Indonesia pushed through a 25 bps rate hike in an out-of-cycle meeting on May 30; the second rate hike will happen soon.

The central banks of the Philippines and Malaysia have also been hiking rates this year to protect their currencies.

The hawkish stance of these central banks has been pushing the bond yields of their countries to levels that are quite competitive when compared to India’s 10-year bond yield.

While the 10-year G-sec yield in India is 7.89 per cent, Indonesia’s benchmark bond yield is 7.10 per cent and the Philippines’ 6.04 per cent. It is, therefore, not surprising that foreign investors have not been averse to pulling money out of India to pump it into other Asian debt markets.

But rather than ask the Fed to go slow with its balance sheet tightening, it would have helped if the RBI Governor had taken corrective action by hiking rates earlier.