The RBI has resorted to many short-term measures to stem the panic caused by the rupee's fall to record lows of 68.80 against the dollar in August 2013. Unfortunately, these steps also have wider implications for the long term and the central bank faces a tricky situation when it reviews its policy for 29 October 2013.
The bond market is certain that the central bank will increase its repo rate by a 25 basis points to 7.75 percent, but when it comes to liquidity, it has no clue as to what the RBI's actions would be.
Will the central bank lower MSF (marginal standing facility) rate by 25 bps from 9 percent to 8.75 percent? Such a cut would take the repo-MSF spread to its normal 100bps. Will RBI remove restrictions on banks' access to LAF (liquidity adjustment facility) by revoking the limit of 0.5 percent of NDTL (net demand and time liabilities)? This limit was imposed in July 2013 as part of the RBI's interest rate defence of the rupee. Before remove liquidity restrictions will the RBI wait for all the dollar-rupee swap windows that are now open (for oil companies and banks that open FCNR B deposits) to close? What is the intention of term repo auctions?
Markets have a lot of questions on the liquidity front. Expectations are that MSF rate will be brought down by 25 bps if repo rate is increased. MSF is the window where banks open funds from the central bank to meet their urgent liquidity needs. Opinion is divided on removing restrictions on LAF borrowings of banks. Markets believe the RBI wanted to develop a money market yield curve through the term repo auctions. The question is what will the RBI achieve by keeping overnight rates at 8.75 percent level (assuming that MSF rate is lowered by 25 bps and banks restrictions on LAF stays)?
The RBI by maintaining the MSF rate as the operational rate will essentially be signalling that all is not over for the rupee. The Indian currency came off 10 percent against the dollar from the lows witnessed in August, largely on the back of the Fed postponing its tapering.
The Fed is expected to maintain bond purchases until early 2014 given the debt ceiling issues the US is facing. The rupee is a beneficiary of the Fed maintaining the size of its asset purchase but the RBI will have to be prepared to face the Fed's tapering at a time when the country is going into general elections.
The RBI will also have to worry about the CAD (current account deficit). Lower CAD on the back of restrictions on gold imports is not sustainable. Import restrictions have to be removed as it artificially keeps down trade deficit. Trade deficit for the April-September 2013 quarter is down 40 percent from the previous quarter on the back of a 76 percent drop in gold and silver imports. The question is what will happen to the rupee once import restrictions are removed?
The central bank will also have to address the questions of growth and inflation. Inflation as measured by the WPI (wholesale price index) is trending at seven-month highs on the back of food inflation that is at a whopping 18 percent levels.
CPI (consumer price index) is at 9.84 percent and has been holding at over 9 percent for the last many months. Economic growth, however, is faltering with GDP growth estimates for fiscal 2013-14 dropping sharply to the decade low levels of 5 percent and below.
Raising repo rates and keeping liquidity tight in the system will pull down growth but will not bring down inflation that is driven by food prices.
Arjun Parthasarathy is the Editor of www.investorsareidiots.com a web site for investors
Updated Date: Dec 21, 2014 00:51 AM