21st June 2016
By now most will have been made aware of Dr Rajan’s announcement to end his term as Governor of the Reserve Bank of India (RBI) effective as at September 4th 2016. As dedicated India Fixed Income investors, we at Rubrics Asset Management are naturally disappointed to see Dr Rajan stepping down from his post given all of the good work that he achieved. However, as always, perspective is required and we believe cause for optimism undoubtedly exists.
In Rajan’s release to the press he highlighted the many positives the RBI had achieved during his tenure. It is sometimes easy to forget that when he took the reins in September 2013 the Indian Rupee was under considerable pressure, inflation was high and growth weak. India was at that time deemed one of the “fragile five”. The fact that over that time inflation has halved, the RBI have been able to reduce rates by 150 basis points (after raising them initially) and increase foreign exchange reserves by some 40% is testament to the manner in which Rajan helped institutionalise the workings of the RBI and put in place frameworks and reforms which we believe will benefit India greatly in the long run. Specifically he highlighted:
- New monetary policy framework – CPI as the nominal anchor and ‘soft’ targeting of the CPI with a target of 4% within a +/- 2% band.
- Creation of a positive real rate of interest for savers
- Building up foreign exchange reserves to record highs In addition, the work done to clean up the banking system through the initiation of the Asset Quality Review is undoubtedly an important structural reform in helping provide future economic stability. In terms of instilling credibility in the RBI, the appointment of Rajan himself was instrumental given his standing in the international community. However what he has done since, not least in championing the move towards a committee based approach thereby removing the ‘key man influence’ can perhaps be even more important in continuing to build credibility.
In essence, by examining the positives Rajan managed to achieve in his short time, we feel India is in a far stronger position than it was in September 2013 and that a strong framework exists for a credible leader to take over and build on the good work.
The potential successors being touted include an existing Deputy Governor (Dr Urjit Patel) and two ex-deputy governors – Dr Rakesh Mohan and Dr. Subir Gokarn. Of these particular candidates we would favour Dr Mohan, as he narrowly missed out in 2008 after Dr Reddy’s retirement, and believe he would serve as a solid replacement to Rajan given his wealth of work in India and abroad. Markets should also take comfort if Dr Patel were to be appointed. He was the author of the monetary policy transformation report based on which the RBI adopted the CPI as the nominal anchor with the ‘soft’ targeting around it. His team had also suggested the formation of the monetary policy committee, which is expected to be rolled out in the coming months. This is crucial as it binds the government and the RBI to a known / transparent target whilst the committee approach reduces the government’s ability to influence any one person at the RBI.
The impact of the news on the bond market has been muted, with bond markets slightly stronger on the day. Having opened up weaker the India Rupee has since strengthened somewhat although we would expect some further volatility in the short term given the element of uncertainty. Another potential source of volatility will be this weeks ‘Brexit’ vote and although the global market movements in the last week suggest a positive outcome, the INR along with all currencies will remain on edge. Looking a little farther ahead, the repayment of FCNR Deposit may give rise to some temporary currency weakness. When he took office in 2013, Rajan raised USD 26 bln from Non Resident Indians (NRIs) as a deposit to be repaid between September and November 2016. Although the RBI has completely covered the requisite amount of dollars in the forwards markets whilst also building up its FX reserves, the markets may remain apprehensive with the INR remaining under pressure for a while.
There is a feeling amongst some sections of a market that Rajan’s successor is likely to be more accommodative and that we should expect more aggressive rate cuts. We don’t subscribe to this theory. If the new governor sticks to the current inflation targeting mandate – 5.0% CPI (by March 2017) + 1.5% real interest rate, further rate cuts are unlikely in the near term. The current CPI level of 5.8% is above the target and only a good monsoon is likely to get it back to 5.0%. This will likely require that the Repo rate remains at 6.5% until the target is reached. If we do happen to see rate cuts materialise, it will most likely be the result of raising the inflation target (from 5.0% to say 6.0%) thereby providing scope to cut rates. Or perhaps more drastically, if the inflation framework is abandoned altogether – a scenario which is even less likely given the current framework has been enacted in law. Either scenario, though positive in the short run, in our view would be negative in the longer term given the deviation it would represent from the current policy framework.
In summary, we were disappointed by Rajan’s announcement as we felt he could have continued to achieve a lot of good things for India as Governor of the RBI. However, perhaps of greater significance is the legacy he has put in place. Most importantly we want to see at new appointment that has the right level of credibility to help solidify confidence in the RBI as an independent institution and enable it to build on the strong foundations laid by Dr Rajan.
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Issued June 2016 CSO 20/06/JG