RBI's fight to check rupee's fall could wallop economy

Late on Monday, the Reserve Bank of India launched a rearguard action to defend the rupee, which has been a downward spiral in recent weeks reflecting the bleak outlook on the Indian economy and the clouds of uncertainty over global financial currency markets over growing concerns of an early end to the ’easy money’ policy in the US.

The RBI raised the Marginal Standing Facility (MSF) rate and the Bank Rate by 200 basis points (0.2 percentage points), which effectively makes it costlier for banks to access funds from the central bank. Simultaneously, the RBI also capped the amount up to which the banks can borrow or lend under its daily liquidity window. It also announced the sale of government of government securities through an open market operation (OMO).

The measures were announced late on Monday after RBI Governor made an unscheduled trip to New Delhi to meet Finance Minister P Chidambaram. A statement put out by the RBI noted that the measures were felt necessary to “restore stability to the foreign exchange market,” particularly after the rupee had “depreciated markedly” in the past six weeks. Countries with large current account deficits, such as India, have been particularly affected, the statement noted.

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[caption id=“attachment_957855” align=“alignright” width=“380”]  The Indian economy faces fundamental problems. Reuters[/caption]

The RBI measures signal a change from the hands-off policy that the RBI has thus far adopted by allowing the rupee to find its level. The latest measures have the effect of staying the hand of speculators who had been emboldened by the RBI’s aloof stance into taking up aggressive positions against the rupee. And although the latest measures are intended as an effort to tame the volatility in the rupee, it also has the effect of ensuring that the speculative positions against the rupee aren’t seen as a one-way bet.

As JP Morgan Chase’s senior Asia economist Jahangir Aziz points out, although the rupee depreciation was triggered by the global shock, the bleeding has been extended by the self-propagating expectations of rupee weakness. “Key to this expectation formation has been the market’s belief that the RBI won’t step in to draw a line in the sand.” And so long as the RBI was signalling it would not step in, the rupee dynamics were taken over entirely by the market’s fears and greed, he notes.

But in looking to defend the rupee, perhaps under political pressure, the RBI may have have had to give up on efforts to address the fundamental problem in the economy today: the absence of growth drivers. The latest move will have the effect of squeezing liquidity in the short term and make it more costly for corporates to borrow. They also effectively dash market expectations - which were always unrealistic - of a cut in interest rates to stimulate growth.

The Sensex has been living in la-la land and expecting a cut in interest rates, but the recent economic data - reflecting a contraction in industrial production activity and mounting retail inflation - has the RBI in a double-bind. Its battle to tame inflation appears for now to have been lost, and it has had to tighten rates even before the macroeconomic engine had revved up. This is the classic double-whammy of slowing growth and rising inflation that represents the sum of all fears for the markets.

In any case, keeping the rupee artificially tethered - in the way that the RBI’s rearguard action suggests - may prove ineffective beyond the short term. India’s economy today faces fundamental problems that cannot be papered over with these half measures.