Does India need sovereign bonds?

Jul 24 2013, 13:08 IST
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SummarySovereign bonds may ease the pressure on the rupee but the govt and RBI need to look beyond short-term measures.

RBI’s defence of the rupee and statements of govt officials suggest the rupee has become too weak. instead of deluding themselves, policymakers might do better listening to what the rupee is telling them

- By Ila Patnaik

In recent months, when government officials suggested that the Indian economy was still strong, most of us thought they were trying to talk up the economy. But RBI’s moves to tighten liquidity and raise interest rates this week seem to suggest that the government really believes that economy is strong enough to absorb large shocks like the those meted out by the RBI. A careful cost benefit analysis of the actions of the past few days suggests that they may be making a very costly mistake. Sovereign borrowing would further add to this cost.

First, why has the rupee depreciated? India has a large current account deficit that needs to be financed by capital inflows. Ben Bernanke’s statement suggesting that rates in the US may rise over the next few months led capital to fly out of EMs. Currencies that were being held up by capital flows witnessed sudden sharp depreciation. Along with India, other Ems with large CADs such as Brazil, Turkey, Indonesia also witnessed a sharp rise in currency volatility and significant depreciation. India’s falling GDP growth, high inflation, poor investment sentiment and high current account deficit were unhealthy fundamentals to begin with. The US Fed provided the trigger.

Second, is depreciation bad for India at this point? It is bad for companies that borrowed overseas tempted by low interest rates. Those who don’t have a natural hedge should either not have borrowed, or have hedged their exposure. On inflation, there may be little exchanger at epass- through as the pricing power of companies in a low growth environment is limited. On the other hand, depreciation is good for export competitiveness and import substitution. Depreciation in a slowing economy can provide a demand stimulus to the economy. (Among the first signs already visible are tourists preferring domestic locations to foreign holidays.)

Third, even if depreciation is not good for the economy, can it be prevented? For a short while and at a very high cost, yes. Remember the basic principles of the impossible trinity: You cannot have a pegged exchange rate, an open capital account and an independent monetary policy at the same time. So we can give up monetary policy

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