RBI and memories of the 2008-09 central bankers panic

Rather than try to prop up the rupee, the RBI should focus on a clear and well-defined nominal target 

 

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The increasingly desperate actions of the RBI bring back memories of what we saw in Central and Eastern Europe in early 2009. Photo: Pradeep Gaur/Mint 

“The Indian rupee rallied sharply to sub 67 per dollar levels on Thursday after the central bank said it would supply dollars to oil companies through a separate window in its latest attempt to shore up the currency,” Reuters reported last week.

I am sure that the Reserve Bank of India (RBI) is pleased with the results of its latest actions. However, it is also clear that the RBI is now conducting monetary policy on a minute by minute basis. It is pure firefighting. It is totally discretionary. The RBI has no monetary rule it follows and monetary policy target. But one thing is certain—this is monetary tightening and the result most likely will be a sharp drop in nominal and real GDP growth. If India enters a recession (I am not forecasting that) then you would have to blame it on the desperate tightening of India’s monetary policy to prop up the rupee.

The increasingly desperate actions of the RBI bring back memories of what we saw in Central and Eastern Europe in early 2009.

As the crisis was unfolding in late 2008 and early 2009, investors were scrambling for US dollars and investors were basically selling all other currencies in the universe. This was also the case for the Central and Eastern European currencies, which came under massive selling pressures as the crisis escalated.

The Latvian crisis was caused by a monetary shock

At that time most countries in Central and Eastern Europe (CEE) were running sizable current account deficits. For example in the case of Latvia a current account deficit was in excess of 20% of GDP and for many other countries in the region the CA deficits were in the range of 5-10% of GDP.

As the crisis escalated the CEE countries were basically facing a sudden stop to the funding of the current account deficits. In that situation you have to choose between either allowing your currency to drop until it is cheap enough to attract currency inflow again or you tighten monetary policy until domestic demand has dropped enough to basically close the current account gap (through a collapse in imports).

The countries operating fixed exchange rate policies—particularly the Baltic States and Bulgaria—thought desperately to maintain their pegged exchange rate regimes. They “succeed” and avoided devaluation. However, the result was a massive monetary tightening and a collapse in domestic demand. In the case of Latvia real GDP dropped in the magnitude of 30% and the crisis caused banking crisis and the country had to be bailed out by the EU and IMF. The peg was saved but the cost to the economy was enormous. Five years later the Latvian economy has still not recovered from the shock.

The 2008-09 CEE Central bankers panic

However, it was not only the countries operating fixed exchange rate regimes in Central and Eastern Europe, which panicked. In fact, the central banks of Poland, Hungary, the Czech Republic and Romania also went into full-scale panic even though the officially had floating exchange rates.

A dreadful example was the Hungarian central bank’s desperate rate hike of 300bp from 8.50% to 11.50%. At the time I commented on the actions:

“Will other countries in the region follow suit and hike rates to defend their currencies? This is clearly a possibility, but we would stress that rate hikes not only have a negative impact on growth, but also on the funding costs for banks in the region—which is of course a serious problem in the present situation with a credit crunch.”

I was not impressed then and the desperate actions of the Central and Eastern European central banks in 2008 and 2009 are something I will never forget. The CEE central banks were completely focused on their sharply depreciating currencies—despite the fact that many of these central banks officially operated a floating exchange rate regime. There was a distinct fear-of-floating that caused them to take desperate and hugely counterproductive actions.

The most shocking event (in Central and Eastern Europe in 2008-9)—in the sense of revealing central bankers incompetence – was probably the decision of the central banks of Poland, the Czech Republic, Hungary and Romania to issue a statement (actually numerous) statements that the four central banks would cooperate to curb the weakening of the four countries’ currencies on 23 February 2009.

As far as I remember the whole thing was kicked off when Romanian central bank governor Mugur Isarescu at a press conference said that the four CEE central banks would act in coordinated fashion to curb the sell-off in the Central and Eastern Europe currencies. Within hours the Polish, the Hungarian and the Czech central banks issued similar statements.

However, there was a major problem. The statements from the four central banks had been extremely badly coordinated so the wording in the statements from the different central banks didn’t really say the same thing. In fact it seemed like that the Polish and the Czech central banks really didn’t think that the Hungarian and Romanian central banks were part of the deal. Hence, within hours it became clear that there really wasn’t any coordination between the four central banks other than about issuing statements that they didn’t like weaker currencies. Needless to say within 24 hours the sell-off in the four CEE currencies continued.

There is no doubt that the actions of the Central and Eastern European central banks in 2008 and 2009 to a very large extent were driven by shear panic. At the core of this panic in my view was the lack of clear commitment among the CEE central banks to a clear rule-based monetary policy. Instead of focusing on their stated nominal targets (inflation targeting and floating exchange rates).

The Hungarian central bank’s desperate rate hike and the failed attempt at coordinated FX intervention were a clear testimony to the failures of discretionary monetary policy. The actions did not stabilise Central and Eastern European markets. They increased volatility and undermined central bank credibility and worse probably deep the economic crisis in all of the countries.

The RBI should end the stop-go policies

This should be a lesson for the Reserve Bank of India. It should forget about trying to prop up the rupee and allow it to float completely freely. Instead the RBI needs to focus on a clear and well-defined nominal target. I would prefer a nominal gross domestic product (NGDP) target, but even a strict inflation target or a price level target would be preferable to the RBI’s present stop-go policies.

And in that regard it should be noted that the Reserve Bank of Australia recently has allowed the Australian dollar to weaken as worries over the Asian economies have increased. The result of this strict non-intervention policy is very likely to be that the Australian economy will come through this shock much better than any of the Asian economies where central banks desperately are trying to prop their currencies.

PS: Last week, both the Brazil and the Indonesian central banks have hiked interest rates to prop up their currencies. It is discretionary monetary tightening, which will only accomplish deepening of the crisis in these countries. I am not too impressed by central bankers in Emerging Markets at the moment. I would, however, notice that the South African Reserve Bank (SARB) under the leadership of Gill Marcus is one of the few EM central banks which has not panicked in reaction to currency weakness. Good job Gill Marcus.

 

TOUHID HUSSAIN

PGDM 3rd SEM