Facebook Pixel Code

RBI, rupee and growth

RBI?s recent measures to prevent a further fall in the value of the rupee has led to concerns of rising interest rates, which, in turn, could drag down growth

What are the recent measures taken by the Reserve Bank of India to tackle the fall in the rupee?

RBI announced its strongest set of measures to stem the fall in the rupee on the July 15. As part of the measures, RBI decided to suck out rupees from the system, in order to push up the value of the rupee relative to the dollar. This was first done by capping the amount that banks can borrow from RBI?s Liquidity Adjustment Facility (LAF) at R75,000 crore and selling government bonds worth R12,000 crore. On Tuesday, RBI adjusted those measures and said that banks can only borrow 0.5% of their deposit base from the LAF window.

Since the availability of dollars in the market has been low for many months and the supply of rupees has been more than adequate, the value of the dollar has risen relative to the rupee. By reducing rupee liquidity, RBI was trying in part to correct this imbalance. RBI also feared that traders were using cheaply available rupees to speculate on the currency markets, making the rupee more volatile. By pushing up the cost of borrowing rupees from the market and the banking system, RBI is trying to discourage such speculative trading.

At the same time, higher domestic interest rates could help marginally in luring back foreign investors to invest in government and corporate bonds in India due to the higher returns offered in comparison to developed markets like the US.

The rupee fell to a record low of 61.21 per dollar in intra-day trade on July 8 but has recovered marginally since then to trade above the 60 level.

Did speculation in the currency markets lead to a fall in the rupee and will RBI?s measures help curb speculation?

Abundant rupee liquidity had led to some increase in speculation on the rupee. Anecdotal evidence suggested that traders were borrowing funds in the inter-bank market, where rates were low, and using those funds to take speculative positions on the rupee. This was adding an element of volatility to the currency markets, which RBI was uncomfortable with. Tightening domestic liquidity will reduce some of this unnecessary speculation on the domestic currency market. However, a large amount of the speculation on the currency takes place in an offshore market known as the non-deliverable forward (NDF) market. This market, which deals in currency forwards, is actively used by foreign investors to hedge their currency risk. However, in some cases when there is a wide differential between rates on the NDF market and rates in the domestic market, traders try and take advantage of the arbitrage opportunity. This arbitrage has, in recent months, added to the pressure on the rupee. Forex experts feel that curtailing this kind of speculation is difficult for RBI, since it does not regulate the NDF market.

At a macro level, the fall in the value of the rupee has been driven by the wide trade deficit and current account deficit that India is facing. Given the uncertainty in the global markets, India may struggle to get an adequate amount of foreign capital to cover this deficit, which, in turn, will lead to a weaker currency since dollar outflows will be higher than dollar inflows. Therefore, curbing speculation will not necessarily stem the fall in the rupee.

Why did government bond prices fell off and bond yields spike in response to RBI?s measures?

RBI?s decision to make liquidity scarcer and more expensive led to investors and banks selling their excess holdings in government bonds in order to conserve cash. This meant that prices of government bonds fell and yields?which move inversely to prices?surged. Investors also feared that RBI may announce further measures such as an increase in the cash reserve ratio (CRR)?the proportion of deposits that banks have to hold in cash?in the coming months. On Tuesday, RBI asked banks to maintain 99% of the required amount on a daily basis.

A section of the market believes that RBI may hike CRR from the current level of 4% at its quarterly monetary policy on July 30 if the rupee continues to remain weak. Economists, however, argue that an increase in CRR will lead to an immediate increase in lending rates, which could hit growth in the economy. The 10-year benchmark bond yield has remained above 8% since the RBI?s announcements.

Are deposit and lending rates likely to rise in the coming months due to RBI?s actions?

Bankers do not plan to raise deposit and lending rates at the current juncture. Since demand for loans remains weak, banks are likely to refrain from raising the cost of loans. At the same time, banks have adequate liquidity, so an increase in deposit rates is also unlikely. While rates are unlikely to go up immediately, hopes that banks will reduce lending rates further have dimmed. For instance, public sector lender Oriental Bank of Commerce, which had recently announced a reduction in its lending rates, decided to defer the rate reduction following RBI?s announcements.

Is the fear that growth will slip in response to RBI?s measures justified?

A number of economists and forecasting agencies have reduced their outlook for growth for the current fiscal year in the last one week. The reduction in forecasts is partly linked to a lack of pick up in industrial activity so far this year. Most economists were also expecting a further reduction in interest rates from RBI this year, which may have helped spur economic activity to some extent. However, with the probability of rate cuts reducing, a boost to growth seems unlikely. Brokerages that have reduced their forecast for growth include Nomura which expects 5% growth compared to 5.6% earlier. Deutsche Bank, Macquarie and Bank of America-Merrill Lynch, all have pegged down their growth forecasts to between 5.3% and 5.5%.

Get live Share Market updates, Stock Market Quotes, and the latest India News and business news on Financial Express. Download the Financial Express App for the latest finance news.

First published on: 24-07-2013 at 03:23 IST
Market Data
Market Data
Today’s Most Popular Stories ×