India's Cash Shortage Leaves the Central Bank Fighting Fires

  • GDP grew 7.3% July-September, will slow next quarter: surveys
  • CLSA sees Patel cutting the policy rate at the Dec. 7 review

Why 2016 is Full of Exceptional Financial Impossibilities

India’s new central bank Governor Urjit Patel is facing fires on multiple fronts as he prepares for next week’s monetary policy review.

A cash shortage triggered by Prime Minister Narendra Modi’s decision to void 86 percent of currency in circulation and an accompanying surge in banking liquidity as Indians deposit their worthless bank notes threatens one of the world’s economic bright spots. Gross domestic product data released on Wednesday showed the economy grew less than estimated in the July-September quarter from a year earlier, piling pressure on the central bank to lower borrowing costs.

As if that weren’t enough, the rupee sank to a record low last week as the prospect of further interest rate increases by the Federal Reserve sucks money away from emerging markets. Foreign investors sold a net $2.3 billion of Indian stocks in November, the biggest outflow in more than a year. Meantime, less than three months into his tenure, critics are already questioning Patel’s low key profile.

"The policy decisions that are being made are very much on-the-go versus a clearly thought out plan that factors in some contingencies," said Rajeev Malik, Singapore-based senior economist with CLSA Asia-Pacific Markets. Patel will cut the policy rate on Dec. 7 to cushion the economy, he predicts.

Read: Slew of U-turns blight Modi’s cash ban and enrage Indians

While GDP growth quickened from 7.1 percent in the April-June quarter, a separate survey shows that the pace of expansion will slow to 6.5 percent in October-December.

Modi’s Nov. 8 move to invalidate existing 500 rupee and 1,000 rupee ($15) bank notes "is likely to create a shock to demand in the near term as vendors are unwilling to accept the old notes and buyers are still struggling to acquire the new ones," Shilan Shah, Singapore-based India economist at Capital Economics Ltd., wrote in a report.

Modi may need until May to replace all the bills, boosting pressure on banks as pay day looms in the cash-based economy -- typically arriving in the first week of every month for most employers. Noticing that shop and small business owners are clinging on to valid bank notes fearing shortages, the monetary authority eased withdrawal limits on Monday.

Liquidity Surge

However, more than 8 trillion rupees have been deposited into banks as Indians look to convert their defunct currency holdings. To mop up the surge, the central bank asked commercial lenders to sequester the deposits as reserves.

The government is also considering raising the amount of bonds it issues to the central bank to use as tools to control liquidity. Once this is permitted, the RBI will review its stance, Patel told the Press Trust of India in a rare interview on Sunday. His silence on the demonetization until then had triggered calls for his resignation and questions about the RBI’s autonomy.

Read: Where’s India’s central bank chief?

"All major policy changes should be explained," said Jan Dehn, London-based head of research at Ashmore Group Plc, which manages about $55 billion in assets. "Otherwise, the RBI is right to keep communications to a minimum and let market participants make up their minds. That is after all what market participants are paid to do, not to stand paralyzed like deer in the headlights."

Hot Tin Roof

Investors looking to hold Indian bonds for a long time should take advantage of the current sell-off, according to Killol Pandya, Mumbai-based head of fixed income at Peerless Funds Management Co., which oversees 9.7 billion rupees. The yield on 10-year sovereign debt rose on Monday by the most since August 2015, paring this month’s decline to 47 basis points.

Indian stocks and the rupee are also set for their worst November performance in five years. The S&P BSE Sensex slumped 5.1 percent on Wednesday, its biggest monthly drop since February, and the rupee is set for its worst month since August last year.

For the coming weeks, investors will turn to the authorities for clarity amid heightening volatility in emerging markets.

"It will take some time for the market to get its confidence back," Pandya said. "It’s like a cat on the hot tin roof.”

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