The late-evening measures of 15 July by the Reserve Bank of India (RBI) are being seen, by and large, as a short-term boost to bring the rupee back to respectable levels, but not a longer term solution to the issues which have led to the rupee’s precipitous decline.
Economists and policywatchers are right when they point out that the measures announced by RBI, which effectively mean a raising of interest rates by pushing up the banks’ cost of borrowings, would only be productive up to a point. In the short term, there could be some stability which would return to the foreign exchange market, but the medium term would continue to see the rupee remaining under pressure.
The twin measures of capping the Liquidity Adjustment Facility at 1 percent of Net Demand and Time Liabilities (NDTL) and increasing the interest rate under the Marginal Standing Facility (MSF) by 100 bps to 10.25 percent would, in the immediate context, serve to bring back some semblance of stability to the forex market. However, the broader and more worrisome effect would be twofold: the structural issues still remain largely unresolved and the increased interest rates would serve to hit an already sputtering economy further.
Already, as argued in Firstpost earlier, the disastrous showing on the industrial production front and the warning signs on the retail (and also wholesale) price inflation point to serious problems afflicting the economy. Coupled with that is the fact that exports have once again performed poorly. A deeper analysis of the IIP figures shows a widespread industrial slowdown, one which is not restricted to just a few pockets, but has spread across most segments of the industrial sector.
While these signals—particularly the lack of clarity on the global front—would mean RBI’s hands are tied as far as reducing interest rates go, the move to effectively hike rates may turn out to be the beginning of a fresh problem.
A report on the RBI moves, put out on 16 July by HSBC, says: "These measures should help to tighten liquidity conditions onshore. For the INR this may provide some short term relief as it shows policy makers' resolve to limit further sharp weakness in the currency. However, the current account deficit and the ability to attract long-term foreign capital inflows are still major hurdles, as is external market volatility. The INR may therefore remain under pressure in the medium term until these factors turn for the better."
The HSBC analysis says while the latest outstanding amount under the LAF facility was just over Rs 92,000 crore according to Bloomberg figures, the new 1 percent limit works out to Rs 75,000 crore. This limit would force banks to go to the MSF window, otherwise not a very popular route for banks. The new limits, together with the 18 July auction which is expected to suck out Rs 12,000 crore, would mean a total of about Rs 30,000 crore of liquidity taken out of the system, the report points out. This will bring marginal borrowing costs closer to the 10.25 percent mark, up from the repo rate of 7.25 percent.
Though RBI was, perhaps, left with little option other than putting out these new measures to curb the volatility in the foreign exchange market, the financial and corporate sector will be hoping that these are reversed once the rupee stabilizes. HSBC, for instance, continues to hold the forecast of the rupee being at 59 to the dollar by the end of the year, a sign that no major breakthrough would likely be achieved by these measures in the medium term.
The key structural factors which still remain to be addressed are the large current account deficit (CAD) which continues to put pressure on the rupee. The recent steps to ease foreign portfolio inflows and ease foreign direct investment norms would need to be taken further if real longer term impact is to be seen. Short of that, together with global uncertainties, the rupee will remain under serious pressure for some time.
Pointing out that Brazil and Indonesia had already taken similar steps to keep their currencies in check, the HSBC report adds: "In our view, for Asian currencies to turn for the better, we need to see lower external volatility and an improvement in regional economic data."
The operative phrase, then, remains ‘key economic data’. And that’s not something within the sole purview of a battle-weary Reserve Bank which has already cut rates to the tune of 125 basis points since April 2012 to supplement the government’s efforts to push growth.
Sourav Majumdar, Editor-in-chief of Entrepreneur magazine.