James Carville, Bill Clinton’s political adviser, famously wished to be reincarnated as the bond market in a 1993 remark frequently ascribed to his boss. Bond vigilantes, a personification of the market-driven consequences of flawed policy, are famous for keeping governments honest, and examples abound.

The disastrous 2022 unfunded tax cuts in the UK mini-budget caused a spike in gilt yields that ultimately forced Prime Minister Truss’s resignation. Sky-high borrowing costs during the eurozone sovereign debt crisis of 2010–11 sharply restricted market access for several eurozone governments, including those of Greece, Portugal, Spain, Italy and Ireland, forcing them to abandon their free-spending ways and embrace austerity.

Rising US bond yields in 1993–94 forced the Clinton administration to pursue policies that resulted in a balanced budget and, eventually, the US government’s last surplus year. Nor is this confined to developed markets. Russia’s 1998 debt crisis was followed by fiscal consolidation, for example.

In less developed markets, however, bond markets are not as deep or liquid as in developed markets, leading to currency vigilantes taking on much of the role of the bond vigilantes. This is, of course, an outcome of the so-called impossible trinity in international finance, according to which a country can sustainably choose any two of independent monetary policy, fixed exchange rates and unconstrained capital flows, despite wanting all three.

Since many developing countries choose to keep interest rates low relative to their growth and inflation, their bond markets do not attract foreign capital, leaving the adjustment burden on their currencies.

In 2018, Turkey followed this low-interest-rate policy most egregiously in recent memory, with interest rates staying very low despite high inflation in the range of 10–25%, ultimately leading to the Turkish lira losing 40% of its value in a single year. In 2023, the low-interest-rate policy led to another slide in the Turkish lira, finally forcing the country to return to orthodox policy and raise interest rates.

Similar examples can be found in Mexico and the Asian financial crisis of 1997, which affected many economies, including Thailand, Malaysia, Indonesia and South Korea. Many of these currency-led crises led to devaluations, tighter fiscal policy and a reset of central bank mandates.

Closer to home, the taper tantrum of 2013 led to a sharp currency depreciation, a spike in bond yields, a sharp sell-off in equities and capital outflows. 

Sounds familiar? 

The government’s response then was similar to its present approach, raising dollars through foreign currency non-resident deposits, imposing foreign exchange market curbs and duties on gold, and restricting overseas investments by domestic investors.

Much of the relief, however, came from a collapse in oil prices from north of $100 a barrel to less than $40 a barrel.

More interesting and long-lasting are the institutional changes to mandates that the Reserve Bank of India had to explicitly adopt. These included the inflation-targeting framework and stronger banking sector regulation to force a clean-up. The former was necessitated by high inflation and a diversion of savings to hard assets such as real estate and gold, essentially reflecting interest rates that were too low relative to inflation.

Currency Pressure
More recently, India’s Chief Economic Adviser has compared India’s current predicament to 1991, characterising 2026 as an inflexion point for India. While this may sound alarmist in the context of growth above 7%, he is not wrong in many ways.

High oil prices are a trigger yet again, as they were during the Gulf War in 1991 and again in 2013. With interest rates below fair market levels, the pressure of adjustment is falling again on currency markets, with sharp rupee depreciation and outflows resulting.

The vigilantes are yet again forcing the government’s hand on reform that can sustainably deliver growth and provide employment in India while it reduces imports and produces exports that the world wants.

Yet supply-side reforms of the nature that lead to these desired results take time. Specific action to serve the immediate purpose is needed if one is not simply to await being bailed out by lower oil prices yet again. That relief may prove elusive if hostilities with Iran escalate after the US midterm elections.

It is important to understand that India simply cannot afford to fight the currency battle any longer without expending even more reserves. The band-aids applicable here have already been applied: FCNR deposit mobilisation, direct access for oil companies, reductions in speculative positions, higher hedging costs and similar measures.

Tax rate adjustments, presently being considered, are likely yet another band-aid, as are possible restrictions, as speculated in the media, under the Liberalised Remittance Scheme. These band-aids amount to fighting the vigilantes. As the US Treasury secretary’s recent feeble and ultimately ineffectual attempts to bring bond vigilantes to heel show, such efforts are unlikely to succeed. Fighting the currency vigilantes will expend even more reserves.

A sustained rise in interest rates remains the last remedy for the beleaguered rupee in the medium term and will be used, sooner or later, if oil prices do not correct quickly. Already, bond yields have risen and implied rupee interest rates in FX forwards are sharply higher and were recently close to 10% for some tenors.

Since rising interest rates curb demand in addition to damaging government finances, this is a necessary last resort, but the vigilantes may force the RBI’s hand sooner than expected. The alternative, letting the currency depreciate, may simply not be palatable given how much has already been committed to stability.

This author has in the past written about the dangers of keeping interest rates too low.

Among these are excessive risk-taking, resulting in possible speculative bubbles, an inflationary impulse as low real rates reduce saving in favour of spending, and a weakening currency.

Much of this has come to pass recently, given the sky-high price-to-earnings ratios of small- and mid-cap indices, a boom in margin funding, the retail losses in options, rising inflation and a weakening rupee.

Conflicting Mandates
Ensuring market-driven interest rates requires an alteration to the RBI’s mandate to extend the efficacy of the inflation-targeting framework established after the 2013 crisis. The RBI today tries to balance too many roles: regulating the currency and bond markets and the banking sector, conducting monetary policy, managing reserves and managing the government’s debt.

These conflict with each other: the goal of keeping costs low on government debt conflicts directly with monetary policy and currency stability, for instance. The former requires lower interest rates while the latter requires higher interest rates.

The RBI has recently refused to issue Treasury bills at the higher rates demanded by market participants, for example, rates that would have a beneficial effect on currency markets. This dichotomy in the RBI’s mandate has forced it to be complicit in suppressing interest rates, resulting in the negative outcomes described earlier. The fox that chases two hares catches neither.

Moving the role of managing the government’s debt to some other government entity is then a logical amendment to the RBI’s mandate. At the end of the day, the government should have to pay market-clearing interest rates, not artificially suppressed ones.

Only this will bring discipline to government finances, allow for appropriate risk-adjusted capital allocation and leave the RBI with fewer conflicts of interest in pursuing its remaining goals. Only sensible capital allocation will keep the currency, equity or bond vigilantes at bay, as they emerge when misallocation-driven mispricing exists.

In other words, allowing interest rates closer to their fair level will incentivise savings that otherwise are forced to seek riskier deployment into small- and mid-cap equities, options, commodities, gold and real estate, leading to speculative bubbles. Leverage, which low interest rates incentivise, will then likely reduce as the cost of borrowing increases.

With a reduction in indiscriminate leveraged flows, such assets will likely be priced fairly, allowing for risk-appropriate capital allocation and providing little incentive for foreign capital to exit. With this, currency pressure from capital outflows will also dissipate.

Higher interest rates will also disincentivise investments into assets such as gold that are a source of currency pressure. Such a normalisation will discourage domestic capital from seeking returns overseas, further reducing pressure on the rupee. With higher interest costs, government spending will need to be targeted and productive, a welcome outcome.

Will this much-needed change come to pass? Since higher interest rates are a necessary outcome of this, there will likely be considerable foot-dragging, as with other major reforms. Turf wars and politicians’ incentives will need to be overcome. The government will want to have its cake and eat it too and will be loath to give up low-cost funding.

Lower oil prices, should they come to pass, may provide relief yet again. The vigilantes, however, will force interest rates higher one way or another if the macroeconomic situation worsens. Perhaps this is then the time to make this change while the situation remains manageable, as part of the long-term reform that is needed for stability.