RBI can calm markets only by staying away from the rupee

The Indian rupee (INR) fell to all time lows of Rs 61.80 against the US Dollar today and there is fear in all markets on the back of the weakening currency. The Sensex and Nifty are down over 2.5% while the ten-year benchmark government bond yield is up 6 basis points on worries of actions by the government and the RBI to curb the rupee fall.

The fresh weakness in the INR is giving rise to speculation of repo rate and CRR (Cash Reserve Ratio) hike by the RBI. The government might impose restrictions on non essential imports and may make noises on more reforms. However, the RBI and the government are helpless and any moves that they may take in the short term will only further deepen the gloom over the economy.

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RBI knows that it cannot use its depleted reserves (at $280 billion as of July 2013 is down by $15 billion since April 2013) to protect the currency. At best by selling $ it can prevent a sustained directional fall. The government does not have any weapons on hand to fight the INR fall. A sovereign/quasi sovereign bond issue may help but the size has to be large enough to make markets sit up and think before shorting the INR.

It is high time that the policy makers realise that the currency fall cannot be prevented. The more they protect the INR the more the opportunity that the market is getting to short the currency. Hence the more the actions policy makers take to prevent INR fall the more the nervousness amongst markets. Equities will fall and bond yields will rise on panic reaction by policy makers.

The markets need soothing at this point of time. It is best that RBI stays away from monetary tightening and the government stops talking about actions to prevent currency depreciation. The economic data since the beginning of this month has given markets enough worry on the economy. Service sector PMI (Purchasing Managers Index) for July 2013 fell to its lowest levels since July 2009 indication falling activity in the economy. Large infrastructure companies such as L&T and BHEL have shown weak first quarter results for this financial year. Defaults amongst indebted companies are rising. There is an issue on regulations over exchanges with settlement being deferred by NSEL (National Spot Exchange).

Growth expectations for the economy are coming off sharply with estimates for fiscal 2013-14 at below decade low levels of 5% seen in fiscal 2012-13. The INR is reflecting the gloom falling over the economy and any measures that could deepen the glow will reflect on the INR.

The RBI now has a new Governor. Dr. Raghuram Rajan is replacing the outgoing Dr D Subbarao. Markets will hope that the former World Bank economist takes steps to clam markets rather than add gloom to the economy.

The INR is seeing fresh weakness since it touched all time lows of Rs 61.21 in the first week of July 2013. The currency gained strength from all time lows on the back of RBI actions to curb speculation. The government on its part took measures to attract capital flows by allowing FDI in multi brand retail and giving the Airline sector a boost by passing the Jet -Etihad deal.

RBI measures of tightening liquidity and pushing up overnight rates by 300 bps only helped take up government bond yields by 70bps. The yield curve inverted with 91 day treasury bill yields trading at over 11% levels. Government’s move on attracting capital flows can only bear fruit down the line when investors see stability in the economy as well as the currency.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com a web site for investors.