On the 3rd June, the governor of the Reserve Bank of India, Urjit Patel, had a chronicle in the Financial Times that was particularly interesting. It is already old news, but the very special fact that a central bank governor writes such a chronicle still deserves some attention. In addition, it is from the central bank of Asia’s third largest economy, which is noteworthy.
The essence of the chronicle is a concern about the American monetary policy, and of the growing government budget deficit in the US. Governor Urjit Patel is of course well aware that when the US is raising interest rates, it affects the financial markets in Emerging Market countries. Those countries are more dependent on dollar liquidity compared to mature economies, and further does their currency and monetary policy correlate with the dollar and U.S. interest rates to a greater or lesser extent. This also applies to India. What Patel doesn’t neglect nor hide, is that the interest rate hikes in the United States can force India and other Emerging Markets countries to raise interest rates. The reason is relatively simple, as Emerging Market countries need to offer a certain risk premium to the United States. Otherwise, investors will buy U.S. government bonds instead of taking the higher risk with investments in bonds issued by Emerging Market countries.
The second part of Patel’s concern is more sophisticated. The U.S. tax reform and the large tax cuts lead to a sharp rise in the government budget deficit. This alone points in the direction of an upwards pressure on the yield curve, but it is in fact the fight over getting investors’ attraction that the central bank governor is worried about. There will simply be a larger supply of U.S. government bonds which very well may attract domestic U.S. investors. This reduces the likelihood that the capital flows less towards India and other emerging markets countries.
Patel’s appeal to the Federal Reserve Bank (Fed) is a counteraction towards the current reduction of the balance sheet (the so-called “tapering”) purchase fewer government bonds than before. However, as Patel argues, the Fed did not know about the American tax reform when the monetary committee at Fed decided and planned the tapering. As a result, Emerging Markets are hit extra hard because Fed reduced the dollar liquidity in the financial markets while U.S. investors might be more attracted by their domestic bond market (U.S. government bonds). But is the honourable governor Urjit Patel right?
The view that the financial markets in the Emerging Markets countries fluctuate when U.S. interest rates are heading higher is true, and also well-known among investors. That part, most central banks in the Emerging Market countries also are prepared to handle.
Though the comment about the fight for attracting investors is more interesting. This consideration should be seen in conjunction with the International Monetary Fund (IMF) that two months ago warned about global debt which now amounts to 224 pct. of the global total GDP. It is higher than at the highest level right before the financial crisis in 2009.
Now, China is the biggest driver, but it does not change the fact that the debt is there. Since more leading central banks likely want to follow the footsteps of Fed by shrinking balance sheets and / or reducing liquidity, the fight for investors’ attention really could intensify much more than the financial market thinks right now.
So, the expressed concern is all-in-all appropriate, though one can discuss whether Patel basically addresses the concerns to Fed or President Trump. Regarding the fiscal policy, it is a political decision, but the monetary policy should surely be Fed’s sole decision. However, the times of politically independent central banks are unfortunately long gone, and actually it’s also quite outspoken in India.
In the end, it is Trump that Patel is trying to influence, though in that case, the message needs to be more powerful than a very well-written chronicle in the Financial Times.
However, Fed still has so much independence that they are aware if there is a risk of turmoil in the financial markets in Emerging Market countries. In such cases, the Fed delays rate hike. Although the current situation is not sensitive enough to delay hikes, and Fed looks like a central bank that goes for four hikes, and not three, this year. One could argue that the chronicle probably didn’t have any immediate effect. In my opinion, Governor Urjit Patel better should address the message to his own supreme chief, India’s Prime Minister Narendra Modi, and not the Fed.
Since many years (and too many years), the major central banks have flooded the financial markets with cheap liquidity through quantitative monetary policy. It has been a poor, but easy solution for a number of countries with internal and external imbalances, such as a chronic deficit in the balance of payments. These countries have also been able to attract investors due to the abundant liquidity. This solution was easier than working intensively with reforms that could strengthen the economy and via a healthy road to attract investors – this challenge is also known to India.
I acknowledge that India had a very strong GDP growth in the first quarter where public investments were of some significance. A quick look at the graphics shows that the Indian manufacturing sector is just in the expansive zone (over 50) but far from strong expansion. In an economy like India’s which includes so many components, I think one should take the consumer confidence (graphic two) with a spruce of salt, but conversely, the development has been pointing lower for a longer period. Therefore, I am pretty excited about the next consumer confidence reading following the strong GDP growth in the first quarter – a higher number would be good.
On the bottom line, I argue that India’s economy is far from the strength it desires, and the chronicle written by governor Patel just increases my worrie, including the consideration whether more storms are under way – but what was Patel’s own answer to the chronicle? It was India’s first rate hike since 4½ years that was announced on June 6th, three days after his Financial Times chronicle. Maybe he was in reality just preparing India for the first hike – if there are more chronicles to come I do not know, but my assessment is that India will raise interest rates several times this year to keep investors’ attraction.