The Indian Rupee Bucks Emerging Market Trend after Reserve Bank Sees Off Government

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The Indian Rupee bucked the emerging market trend Tuesday by advancing against the G10 basket after a Reserve Bank of India (RBI) meeting came and went without a resignation of Governor Urjit Patel. 

Markets had been on edge Friday following rampant speculation that Patel would resign at a Monday board meeting in protest over the government's efforts to intefere in the bank's affairs.

This led analysts to warn that investors could easily perceive the institution's "independence" as having been undermined. 

The finance ministry had used a clause in the Reserve Bank of India Act 1934 to pressure RBI officials into relaxing regulations designed to reduce the stock of bad loans washing around in the financial sector, and handing "excess" foreign exchange reserves over to the government.

"The Reserve Bank of India (RBI) and the government found common ground on some of the points of contention between them at the Bank’s board meeting yesterday. But key issues remain unresolved, and the sense that the government is trying to strong-arm the central bank, to the detriment of its credibility as an independent inflation-fighting institution, will linger for a while yet," warns Shilan Shah, an economist at Capital Economics. 

In the end Monday's board meeting ended with a statement from the RBI saying its "Prompt Corrective Action" framework addressing toxic debt in the shadow-banking sector would be reviewed by an internal committee. Although it followed this with a separate statement saying it has already subjected another troubled institution to special measures. 

The bank also says it is referring to an internal committee the finance ministry's demand for "excess reserves" to be turned over to government. That committee will be comprised of RBI and government representatives, who will both seek to determine the optimum level of reserves the bank should have. 

Just about the only concession the RBI appears to have made to the government was its decision to defer until 2020 the implementation of a Basel Accord regulation that requires banks to supplement their existing buffers with additional capital equal to 0.625% of risk-weighted assets.

That means new regulation will not stymy lending in the real economy for another year, or until well after the 2019 election. The government's demands had all been perceived by the market as being politically motivated, given the Narendra Modi administration faces its first re-election test in the New Year and growth will be a key focus for voters.

"One way that government influence could now manifest itself is through the formation of the two panels. Panels stacked heavily in favour of members of government would undermine the RBI’s credibility, which in turn could lead to a rise in bond yields and weigh on the rupee," says Shah. 

The USD/INR rate was quoted -0.16% lower at 71.49 Tuesday, denoting a stronger Rupee, but has now risen by 12% in 2018. It had risen as much as 16% during the 10 months to the beginning of November.

The Pound-to-Rupee rate was -0.57% lower at 91.56 , denoting a stronger Rupee and weaker Sterling, but has gained 6.2% this year. It had risen almost 10% going into November.

The Indian Rupee was higher against all major currencies and most of the G10 basket Tuesday, denoting a performance which stood in contrast to that of other emerging market currencies.

Bond and currency markets have a severe aversion to political meddling in the affairs of central banks given the risk that politically-motivated decisions can pose to financial stability and creditors of sovereign governments.

Governments can easily be tempted to pressure central banks into keeping interest rates low for electoral reasons, but such decisions almost always gives rise to fears over the inflation outlook. This leads creditors to demand even higher rates than they otherwise would have when lending to governments.

The 2018 crisis in Turkey, which saw the Lira depreciate by as much as 60% at one point, demonstrates just how messy things can get when governments come through the back door to appoint themselves as de facto heads of a central bank.

Capital Economics' Shah said last week that it will not have escaped the market's notice that the government's demands of the RBI would boost growth and inflation at a time when the economy is already running hot and the central bank is attempting to tighten policy.

The RBI has raised its interest rate twice in 2018, taking it up to 6.5%, but policy tightening almost always leads to slower economic growth further down the line. 

"We have revised our end-2018 forecast for USD/INR from 76.5 to 74.0. However, the potential escalation in the political uncertainty amid legislative assembly elections in five states this month, and in the run-up to the national elections in May 2019, will sustain the weakening bias on the INR. We continue to see the USD/INR rising past the 75 level against the USD in the next three-to-six months," Prakash Sakpal, an economist at ING Group, writes in a note to clients last week.

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