Why RBI move to pull up rupee will cause more pain than gain

RBI curtailing liquidity to pull up the Indian Rupee (INR) has caused more pain than gain.

The INR gained by one rupee from levels of Rs 60.20 to the USD to Rs 59.20 while the ten-year benchmark bond, the 7.16% 2023 bond price fell by Rs 3. In fact the bond market pain is not over yet while the INR is actually starting to fall again. The INR has fallen to levels of Rs 59.50 after the initial rise to Rs 50.20 post the liquidity tightening measures.

Bond markets are facing the prospect of a prolonged spell of uncertainty. Markets will worry about rate hikes in the 30 July 2013 policy review. Liquidity conditions will stay tight as banks hoard liquidity on the back of worries of more liquidity tightening measures and interest rates are unlikely to come off in the economy.

 Why RBI move to pull up rupee will cause more pain than gain

The worry now is "what if the INR goes back over Rs 60?" Will the RBI tighten liquidity further and raise rates? The damage to market sentiments has been severe and RBI cannot undo the damage quickly as then it would seem as if the central bank acted in haste.

The first hiccup of the RBI moves was seen in the State Development Loan auction held on the 17th of July. Ten states participated in the auction and the cut offs for the ten year loan ranged from 8.50% (Harayana) to 9.48% (West Bengal). The wide disparity in cut off yields was due to markets bidding negatively in the auction. Five states did not accept the auction bids.

The second hiccup was seen in the 91 day and 182 day treasury bill auction held on the 18th of July where the RBI rejected all the bids for the Rs 12,000 crores auction, as bids would have come in way too high from market levels.

RBI had to open a repo window for liquidity requirements of mutual funds as the sharp rise in yields could lead to large scale redemptions from fixed income funds. The liquidity tightness would mean that there could be no buyers for the securities mutual funds sell to meet redemptions.

The sharp rise in government bond yields will make borrowing costlier for the government as well as corporates. The government cannot afford a rise in interest costs at a time when the economy is slowing down. The government is fiscally constrained and cannot borrow and spend and whatever spending it has to do should come out of budgeted borrowings.

Credit growth in the economy has fallen to multi year lows of 13.7% and rise in borrowing costs for corporates will slow down credit growth further.

Investors in bonds and equities will be inclined to pull money out of the markets given the uncertainty on liquidity, interest rates and the INR. Money going out of markets will further take up bond yields and pull down equities leading to fresh worries of FII sales and further falls in the INR.

The fact that RBI announced its liquidity tightening measures late on 16 July suggests the government involvement in the measures. The move came after a meeting of the PM, FM and the RBI Governor. The government is definitely hurt by the RBI measures as it's borrowing cost are higher and prospects of a falling economic growth loom ahead.

The worry now is "what if the INR goes back over Rs 60?" Will the RBI tighten liquidity further and raise rates? The damage to market sentiments has been severe and RBI cannot undo the damage quickly as then it would seem as if the central bank acted in haste.

RBI has many more things to worry about now and markets are too nerve stricken to take any position based on fundamentals.

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

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Updated Date: Dec 20, 2014 20:57:45 IST


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