Rajan effect: Why media got it all wrong
The law of causality is one of the most misunderstood ones in economic journalism. The law states that every effect must have an 'adequate antecedent or simultaneous cause'. Or causes. However, in day-to-day instant journalism, any effect tends to be attributed to a proximate cause, never mind the tenuous linkages.
The chances are that the big moves in the markets, or even in the rupee’s value, are not the result of one or two factors,
but a whole host of factors
If one speech could raise the value of Rupee from 68 to 64 to $, surely Rajan must make more speeches. However, is Rupee Strengthening because of what he said or inspite of it?
The law of causality is one of the most misunderstood ones in economic journalism. The law states that every effect must have an 'adequate antecedent or simultaneous cause'. Or causes. However, in day-to-day instant journalism, any effect tends to be attributed to a proximate cause, never mind the tenuous linkages. Case in point: since both the rupee and the markets have looked rejuvenated even since Raghuram Rajan took over as Reserve Bank of India (RBI) Governor on 4 September, the pink press has gone gaga over 'RockStar Rajan' and how he has changed the game.
At fault is the tendency to attribute the rise or fall of any index or price to one single event: the return of FIIs to the market, an improvement in the trade deficit in one month, or some economic number (consumer prices, index of industrial production, etc). Thanks to Tuesday’s rise of the Sensex by 727 points and the rupee’s rise above Rs 64 to the US dollar, we today have mindless headlines all over. The Economic Times believes that the economy is 'warming up' and the currency market is 'in love with Rajan', due to which the 'rupee may flirt with 60'.
Business Standard noted on Wednesday that the return of foreign institutional investors (FIIs) and the cut in August’s trade deficit due to the sharp fall in gold imports has lifted markets. Business Line adds another cause: the easing of the Syria crisis. None of them are obviously wrong, but the real problem is that these are explanations after the event. When the Sensex rises, it is easy to attribute it to a proximate event (Rajan’s entry, an improving trade deficit) when a simpler explanation (but not the only one) may be the market’s tendency to move both ways in bursts depending on current sentiment - among other things.
The chances are big moves in the markets, or even in the rupee’s value, are not the result of one or two factors, but a whole host of factors. And the reason why they rise and fall in big chunks may be related to the fact that most traders and investors tend to go with the flow. If the flow is in one direction today, it takes a lot of courage for money managers to do in the other direction. No one can afford to swim against the tide in any market. This is why prices tend to over-correct on either side. Consider how the same events can be used to move the markets both ways.
Let’s assume the markets love Rajan – as ET assured us on 11 September. “The local currency had its best four-day rally in four decades after RBI Governor Raghuram Rajan moved to reverse sentiment on policy-making, introducing several measures soon after taking over last Wednesday.”
If one speech could raise the value of the rupee from 68 to 64 to the dollar, surely Rajan must make more speeches. However, is the rupee strengthening because of what he said or inspite of it? Among other things, Rajan said that his primary job was to retain the value of the rupee, presumably by dealing strongly with inflation. If this means retaining interest rates at high levels for a while longer, should the markets be celebrating? Or is the market presuming that Rajan will anyway cut rates? We will know only on 20 September.
Who knows, the markets may not think he is a hero, as he himself noted on 4 September, when he said his job was to do the right things, and not just popular things. Or take the FIIs’ so-called return to the markets. While it is true that FII investment in equity has been positive this month and the year, it has been negative in debt. The question is: are the FIIs positive in equity because they want to stay invested in Indian companies, or because they can’t really leave?
Currently, FIIs are the only big players in the markets. When they sell, the markets tank; when they buy, the markets soar. When they sell equity or debt, the rupee also weakens. Given this, they know that if they sell, they will lose on two counts: exchange losses on a falling rupee, and big losses on stock prices.
Their decision to stay may be related to avoiding losses till the political air clears. If more money is flowing in, it may be because FIIs still underinvested in India suddenly find the exchange rate attractive enough to buy rupee assets. Raghuram Rajan may have little to do with it.
Or take the trade deficit, which has fallen in August to under $11 billion. While exports have surged 13 per cent, imports are down 0.7 per cent despite the rise in oil prices. While the rise in exports and levelling in imports are good signs, they are also bad news. Falling imports means domestic growth is slowing. And exports, which are growing, may be a small part of the economy. Falling imports also mean lower customs revenues – which means a bigger deficit. The question is: will exports rise faster than falling imports so that the net growth impetus is positive? We don’t know that yet.
Then, let’s consider the rupee’s rise. Is this good or bad? From an inflation perspective, it is certainly good, since oil prices will come down in rupee terms. But as the rupee falls, imports could start rising again - and we would get back into a CAD problem. And let’s not forget, the export rebound and the import crunch is less due to the government’s efforts and more due to the natural tendency of the markets adjusting to new prices created by a falling rupee. We can say that Rajan helped the rupee rise, but the explanation may be simpler: reversal to the mean.
For some time now, everyone has been saying that the rupee has overcorrected. Also, with a good monsoon and improving agricultural prospects, the economy may be about the bottom out. This means the excessive gloom of the last one year may be replaced with some hope. If the rupee and the markets celebrated excessively during 2003-08, they corrected after that, and then overshot during 2012-13.
We are probably seeing a reversal to the mean. So don’t call it the Raghuram Rajan effect. No doubt he is a great Governor to have, but hello, all he has done so far is make an invigorating speech. We have to wait till 20 September to see what action follows his words.
22 July 2019 2:01 PM GMT