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Rupee will be the focus of RBI's monetary policy on July 30 instead of growth and inflation

Inflation is at a near-three-year low of 4.86% and economic expansion is crawling but sliding currency is more concerning.

Jul 29, 2013, 09.20 AM IST
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MUMBAI: For the first time since the 1997 East Asian crisis, the Reserve Bank governor's prognosis for the Indian rupee will take centre stage at the quarterly monetary policy on July 30, instead of interest rates.

In what could be the last quarterly monetary policy unveiled by Duvvuri Subbarao, the bureaucrat-economist will explain his recent actions that have left most investors flummoxed.

When inflation is at a near-three-year low of 4.86% and economic expansion is crawling, it would have been a no-brainer to forecast an interest rate cut by the monetary policy maker. But hardly anyone is doing so, thanks to the sliding currency.

All the 15 economists polled by ET were unanimous that repo rate - the rate at which the central bank lends to banks - and cash reserve requirement - the portion of deposits that needs to be kept with RBI - will remain at 7.25% and 4%, respectively. So will the statutory liquidity ratio - the portion of deposits to be held in government bonds - at 23%.

RBI's reaction to the sliding rupee, which touched life lows this month, is drawing comparison to former governor Bimal Jalan's shock therapy of steep interest rate and reserve ratio increases in January 1998, reversing an easing cycle. Jalan's measures lasted about three months.

Too many imponderables

Investors are looking for guidance from Subbarao on when his tightening by stealth will end.

But an answer may be elusive given that there are too many imponderables. There are conflicting signals from the ruling class, which is neither for higher interest rate to lure US dollars nor for sovereign bond sale to show its commitment to defending the rupee.

 
"What is going to be important is the language and guidance on how long the measures will last," said Agam Gupta, managing director, fixed income trading, Standard Chartered Bank. "Liquidity is going to be tight next week because of their measures. Looking at the growth-inflation dynamics, I don't think they are looking to raise rates immediately."

There is an expectation that RBI's measures may last just a few months, and that the compulsion to revive growth could lead to it begin easing soon.

"If the rupee stabilises for 1-2 months, RBI is likely to reverse these moves," says Neelkanth Mishra of Credit Suisse. "When they reversed their moves in Mar '98, two months after raising rates, trade deficit was still rising and capital flows were still weak and negative."

The rupee's fall to a record low of 61.20 to the US dollar on July 8 triggered a series of measures from the central bank that pushed up yields on bonds and commercial paper. The currency also rose to end at Rs 59.08 on July 26. Blaming excess liquidity in the system for speculation on the currency, RBI twice capped the amount available under the liquidity adjustment facility. From a theoretically unlimited amount, it is now at Rs 37,000 crore.

On July 15, the central bank raised penal interest rates under the Marginal Standing Facility by 200 basis points, effectively making it the repo rate for the short term. It is at 10.25%.

Yields on three-month Treasury bills rose to a high of 10.81%, from 7.27% on May 27, and three-month commercial paper traded at 11.29% on July 25, almost 286 basis points higher than 8.43% in May. A basis point is 0.01 percentage point. Yields on 10-year bonds, which fell to a multi-year low of 7.09% on May 9, rose to 8.13% by July 26.

The central bank's tightening was induced by the sudden outflow of funds from Indian debt in May and June, which in turn led to an accelerated slide of the rupee. Indian bonds have become unattractive after yields on US bonds surged to 2.7% following Federal Reserve Chairman Ben Bernanke's hint at slowing the $85-billion monthly bond purchases that flooded emerging markets with greenbacks.

Since May, foreign funds have pulled out Rs 51,640 crore from Indian debt and Rs 6,021 crore from equities. But they are showing signs of buying Indian debt again with bids for more permits at a recent auction than on offer.

RBI will defer raising repo rate as long as possible since it does not want to be seen stifling economic recovery. Growth crawled at 4.8% last fiscal. Nomura, Bank of America Merrill Lynch and others have reduced their forecast for this fiscal in recent days.

The fact that the Index of Industrial Production contracted 1.6% in May and the Wholesale Price Index is at 4.86% are not helping either because consumer inflation has started rising again. The Consumer Price Index gained 9.87% in June and is poised to rise further since prices of diesel and food articles are climbing.

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