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The central bank is looking more like a captain of a ship in the midst of a violent storm, punching away at every button in the hope of controlling the ship and steering it in the right course. Unfortunately the rudder has a mind of its own and just does not seem to react to its captain’s instruction.
RBI has its job cut out when it comes to controlling the economy. It has to strike a balance between inflation, growth and interest rate. At the same time it is not supposed to take its eye off the value of rupee in the foreign exchange market.
Over the last few years, the central bank managed to steer the ship through rough weather by focusing on inflation at the cost of growth and interest rates. Growth was rightly sacrificed in favour of inflation. Interest rates were left to languish at higher levels which affected growth. The central bank needs to be commended for taking the ship out of the Lehman crisis storm relatively unscathed.
However, the central bank has now hit extreme rough weather caused by the violent movement of the currency. Its recent move of increasing margin money in futures market and asking oil companies to purchase dollars directly failed to have much of an impact in controlling the currency. Foreigners continue to withdraw their investment both from the equity and debt market adding pressure to the rupee.
There is little that the RBI can do to prevent money outflow from the equity markets, especially since the US markets are doing well. It has one way of controlling debt outflow and that is by increasing interest rates. US interest rates have gone up after Ben Bernanke, Chairman, Federal Reserve hinted at tapering their bond buying program. This resulted in the difference between the US interest rate and Indian interest rate to narrow.
On an interest parity basis, in order that the difference between the two countries is maintained, Indian currency should depreciate, which it did. But a weaker rupee is not something that either the government or the RBI wants. Thus the only tool left in the hand of the central banker was to increase interest rates in India.
This was managed on Monday evening by reducing liquidity of the rupee. A massive exercise to suck out liquidity by capping the liquidity adjustment facility and conducting open market sales of government securities is being carried out. As a result, short term interest rates have been increased, making it costlier for banks to raise money.
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There was an immediate reaction to RBI’s move. Equity markets fell by nearly 300 points while bond rates shot up by 50 basis points (the circuit filter was removed on Tuesday by RBI in anticipation of direction of yields) and rupee appreciated to 59.35 as compared to the previous close of 59.89 against the dollar.
This is perhaps the most drastic step taken by the central bank in recent times to contain currency volatility. In doing so, the central bank has once again raised questions over its growth stance as higher MSF rates will prevent bankers from pushing money in the economy as they would like to keep liquidity to themselves. They would like to lend only if they can charge higher interest rates. In other words the move would make doing business in India costlier.
Left with little option in the middle of a storm, the central bank has jammed the brakes hard, but in doing so, it risks damaging the growth engine. A ray of hope suggests that the move is likely to be a temporary one with the central bank expected to ease once volatility stabilises. How will it then stop outflows is a battle to be fought on a different day. RBI’s moves have ensured that the battle has been won for the day.Tomorrow is another day.
