Every credit policy of the Reserve Bank of India (RBI) is a keenly watched event for the changes in policy rates (repo, CRR and SLR) it could contain. Tuesday's event is likely to be scrutinised not only for policy rates but also for its analysis and explanation towards the recently announced liquidity tightening measures. At the core has been the fast depreciating rupee.
The rupee depreciated against the dollar from 53.80 in April-end to a high of 61.20 in early July. While some volatility in the markets is expected on account of lags and leads in demand and supply, this near 14 per cent depreciation needed a course correction. The main trigger for this depreciation was not from any adverse domestic development. Instead, the trigger was the US Federal Reserve's indication to start tapering its Quantitative Easing (QE) programme and bringing it to a halt by mid-2014.
The QE is conducted by means of the Fed purchasing US treasuries and other debt securities. The Fed declared it was likely to slow down its pace of such purchases. As a result, US bond yields rose and the dollar strengthened across all currencies. Emerging market currencies have suffered more depreciation as global investors reacted with re-allocating a part of their investments from emerging market assets to the US markets. It is well known that given India's current account deficit (CAD), capital investments from foreign institutional investors (FIIs) is an important ingredient towards keeping our balance of payments stable. The rupee's depreciation worsened as we ran out of a quick replacement of such FIIs with another capital inflow source.
For the immediate course correction need, focus is, therefore, back on capital flows. Here, RBI has followed basic economics, which prescribes that a higher interest rate attracts capital. To achieve this, they have used liquidity tightening as a means to raise short-tenor interest rates. Such rates might be found attractive by non-resident Indian depositors and debt FIIs, especially the sovereign and pension funds. Though we are yet to see investing from FIIs return, the dollar-rupee rates have begun to stabilise in a below-60 zone. In the eventuality of the spot crossing 60 again, dollar-denominated sovereign bonds, issuance could be another means of getting the dollar capital back.
Should the foreign exchange rate volatility subside, one can expect RBI to relax some of these tough measures. One particular measure that needs the earliest correction is to revert the minimum daily cash reserve ratio maintenance from 99 per cent to 70 per cent. This measure can impede, at the margin, the flexibility that retail and corporate customers have in completing their day-to-day banking transactions. It, very directly, puts the cost on to the banking system. Instead, similar liquidity tightness can be achieved through further issuance of cash-management bills, including, those with fortnightly tenors.
The author is head, fixed income and currency trading, Deutsche Bank India
The rupee depreciated against the dollar from 53.80 in April-end to a high of 61.20 in early July. While some volatility in the markets is expected on account of lags and leads in demand and supply, this near 14 per cent depreciation needed a course correction. The main trigger for this depreciation was not from any adverse domestic development. Instead, the trigger was the US Federal Reserve's indication to start tapering its Quantitative Easing (QE) programme and bringing it to a halt by mid-2014.
The QE is conducted by means of the Fed purchasing US treasuries and other debt securities. The Fed declared it was likely to slow down its pace of such purchases. As a result, US bond yields rose and the dollar strengthened across all currencies. Emerging market currencies have suffered more depreciation as global investors reacted with re-allocating a part of their investments from emerging market assets to the US markets. It is well known that given India's current account deficit (CAD), capital investments from foreign institutional investors (FIIs) is an important ingredient towards keeping our balance of payments stable. The rupee's depreciation worsened as we ran out of a quick replacement of such FIIs with another capital inflow source.
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With a medium-term perspective, both the government and the regulators have been gradually converting their resolve to counter the CAD issue with concrete action. These have included (a) raising duties on gold imports, (b) introducing inflation bonds as an alternate to use of gold for inflation hedging, (c) progressively reducing subsidy on fuel prices, which might help reduce the growth in crude oil imports, (d) simplifying the controls structure around debt FIIs, participation. Clearly, more steps need to be taken to make our exports competitive and reduce dependence on imports. Such steps, however, will take time to deliver.
For the immediate course correction need, focus is, therefore, back on capital flows. Here, RBI has followed basic economics, which prescribes that a higher interest rate attracts capital. To achieve this, they have used liquidity tightening as a means to raise short-tenor interest rates. Such rates might be found attractive by non-resident Indian depositors and debt FIIs, especially the sovereign and pension funds. Though we are yet to see investing from FIIs return, the dollar-rupee rates have begun to stabilise in a below-60 zone. In the eventuality of the spot crossing 60 again, dollar-denominated sovereign bonds, issuance could be another means of getting the dollar capital back.
Should the foreign exchange rate volatility subside, one can expect RBI to relax some of these tough measures. One particular measure that needs the earliest correction is to revert the minimum daily cash reserve ratio maintenance from 99 per cent to 70 per cent. This measure can impede, at the margin, the flexibility that retail and corporate customers have in completing their day-to-day banking transactions. It, very directly, puts the cost on to the banking system. Instead, similar liquidity tightness can be achieved through further issuance of cash-management bills, including, those with fortnightly tenors.
The author is head, fixed income and currency trading, Deutsche Bank India