India is monetarily diverging from the west
In the last few months, the Indian government has diverged in many ways from the West. They continue to buy Russian oil despite the sanctions imposed by the West. India has also continued to have trade relations with Russia. One interesting area of divergence is now seen in monetary policy. A monetary policy is considered divergent if it is not in consonance with what large parts of the developed world is doing. During the global financial crisis of 2008-09, India also adopted a policy of monetary loosening. Similarly, during the COVID pandemic also India put ample liquidity in the hands of the people. However, while India also started its hawkish journey almost at the same time as the US in 2022, it has stopped rate hikes in February itself. On the other hand, the US and even UK have continued to raise the benchmark interest rates to control inflation. Why this divergence?
Why has India diverged on monetary policy?
The US hiked rates in its March policy and again in its May policy by 25 basis points each. On the other hand, the last rate hike by the RBI was in February 2023. It is not that inflation has come under control, but the RBI has other reasons to diverge monetarily. For example, even during the COVID crisis, the RBI never cut rates as aggressively as the Fed. In fact, Fed cut rates all the way down to the range of 0.00%-0.25%. Secondly, RBI has underlined that it has larger growth challenges in India. For instance, the spike in repo rates impacted most corporates. Net margins narrowed and solvency ratios weakened, which led the FICCI to demand a slowing of rate hikes. Above all, the RBI has indicated that April 2023 was a pause and not the end of rate hikes. RBI has still kept its options open.
What Jerome Powell said in his May statement
India’s monetary divergence looks starker since the US Fed continues to be hawkish. Despite a growth slowdown and the developing banking crisis, Jerome Powell refused to go easy on rate hikes. He has underlined that the Fed would hike rates till inflation was beaten down.
- Since March 2022, the Fed has hiked rates by 525 basis points to the highest level since 2007. The good news is that Powell has not given any hawkish guidance. However, he specifically underlined that the Fed was open to more rate hikes if required.
- Hard landing has been a big debate in the US. However, in the Fed statement, Powell expressed confidence that an economic recession can be avoided. While the confidence is good, weak Q1 GDP and the banking crisis do point to a likely recession.
- The interesting aspect is that even as Jerome Powell maintains his “hawkish if required” stance, market signals are not in sync. Powell has ruled out rate cuts in 2023 but markets are indicating 100 bps rate cut by December 2023 and 200 bps by mid-2024.
- Powell has also focused on the positive side of the banking crisis in mid-sized US banks. The banking crisis resulted in less availability of credit in the US economy. To that extent, the banking crisis has also partially played the role of monetary policy tightening.
Now we come to the big issue. What are the implications of RBI monetary policy diverging from the Fed policy?
Monetary divergence can be risky in multiple ways
While the Fed hiked rates by 500 bps since March 2022, RBI hiked rates by 250 bps between May 2022 and February 2023 and stopped after that. What does this divergence imply?
- One of the risks of monetary divergence is debt market flows. For example, today the real rates of interest in India are over 1% while it is still negative in the US. But, another rate hike and a fall in inflation can change the equation. Much of India’s foreign flows are portfolio flows and hot money can change direction quite fast.
- One reason for the hawkishness given by the Fed is that nominal growth is still robust. If inflation is controlled then real growth will automatically pick up. India has decided to pause on rate hikes to help the industry with lower cost of funds. However, that comes with the concomitant risk of weaker real growth if inflation is high.
- It has been historically observed that monetary divergence creates volatility and liquidity disruptions in the bond markets. One of the reasons bond market disruptions were avoided during the GFC was that monetary policy was in sync. Volatile portfolio flows can lead to huge bouts of volatility in the bond markets too.
- The Fed has traditionally maintained the stance that the Fed would focus on price stability rather than on being industry-friendly. Price stability has much bigger dividends for the macroeconomy in terms of purchasing power of households, consumption spending and demand in the economy. These can get impacted by higher inflation.
- Lastly, the monetary divergence has a cost in currency terms. Fed rate hikes make the dollar dearer and the rupee weaker. If the current divergence deepens, then there could be flowing out of the Indian rupee. We have seen how this kind of monetary divergence led to a run on the rupee in 2013. After all, the Indian rupee does not have the exorbitant privilege of being the currency of choice when it comes to trade and payments.
In a sense, monetary divergence is risky. It may look brave on paper, but the practical costs can be quite high.
Content Source: RBI and US Federal Reserve