Market analysis: Strict RBI policy helps Indian economy to rebound

Fiscal policy sustained the rupee and led to the Indian economy rebounding.

Queues at ATMs after India’s demonetisation change contributed to a decrease in productivity. Dhiraj Singh / Bloomberg

Alphonse de Lamartine once said: “Experience is the only prophecy of wise men”. A century-and-a-half after the French poet and politician’s death, the longevity of that line has been proven again.

About three months after widespread predictions of a slump in the Indian economy following the Indian prime minister Narendra Modi’s decision to scrap 500 and 1,000 rupee bank notes last November, the Cassandras appear to have been listening to the wrong wonder snakes.

To clarify, there was a sharp decline in India’s economic activity following the large denomination notes being cancelled as valid currency by the Indian government. However, a significant portion of that decline can be attributed to the many man hours spent by millions of Indians queuing to withdraw their own money from bank accounts and others queuing to deposit the soon-to-be cancelled notes.

Indeed, while the economic slowdown was reflected in the sharp decline of the rupee’s value during November, and a steady testing of the currency in January and February, it finally recovered this week.

So what factors sustained the rupee and led to the Indian economy rebounding? In my opinion it was the strict fiscal policy of the Reserve Bank of India (RBI), which held its ground and refused to sway to the government’s requests to come and clean its mess by lowering interest rates at its December 7 meeting.

The RBI’s discipline, coupled with Mr Modi’s experience and respect for its advice, has been proven right once again. On the RBI’s side, it has been consistently flexible on inflation targeting, focused on tempering volatility and not establishing an artificial currency exchange rate to achieve high foreign currency reserves. On the government’s side, it has been the combination of a disciplined budget and current account deficit.

The economic outlook for India is strong. Through the several industries and varied trading partners of its diversified economy, India is in better shape than any of the other Bric economies. The country also remains a powerful player in Asia, where other economies rely heavily on the US market which, under the US president Donald Trump, has become fickle at best.

So was Mr Modi’s demonetisation of the high value rupee notes the correct policy? I think it was a blunt and regressive measure that is unlikely to achieve its stated aim of clarifying the “dark economy”, preventing terrorism financing and fighting corruption.

The dark economy exists because of high barriers of entry into the formal economy, barriers built on over regulation, lack of education and a lack of available financing. To its credit, Mr Modi’s government has specific policies – currently in the process of implementation – that do away with unnecessary regulation, improve education and provide access to grass roots financing at all levels of the economy.

The strengthening of institutions through rule of law is the one proven way to fight corruption, not the nationalisation of private property at the expense of public trust in the currency. I am afraid that in this respect and despite his experience, Mr Modi’s move is a total negative.

The excuse of battling terrorism financing is vacuous at best. Terrorism exists because of failed politics and social discord. An economic cure is unlikely to be effective when dealing with terrorism financing. That was the precise conclusion by the September 11 commission on its investigation of the financing of the terrorist attack against the United States, which is argu­ably the most extensive research done on the subject. Sadly the one asset necessary to carry out acts of terror is a disillusioned and confused young mind – not money.

To conclude, the demonetisation move was ill-advised and poorly executed, but it is unlikely to cause a lasting detrimental effect to the Indian macroeconomy.

India’s sound macroeconomic fundamentals are likely to rescue Mr Modi from this mistake, but sadly many middle- class Indian families who had their savings in high denomination notes but were not able to afford precious metal bullion, real estate or other high value physical assets, will not be as lucky in the micro-economy of daily life.

Mario Camara is the head of Saxo Bank Dubai

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