RBI may prefer 40/$ level, say analysts

The Reserve Bank of India's (RBI) apparent "tolerance level" for the appreciation of the rupee has been increasing, much to the surprise of many in the financial markets.

But Rs 40 to a dollar seems like a dead-end for the currency pair, as the central bank would defend that level with all its ammunition, treasurers and economists said.

Until the local unit strengthens to that level, the central bank is expected to remain passive in the foreign exchange and money markets and avoid raising banks' cash reserve ratio to tighten liquidity, they said.

Shifting goal post
"The RBI appears to be tolerating a much greater degree of rupee strength than previously expected," said Sundeep Bhandari, managing director and regional head - global markets, South Asia, at Standard Chartered Bank.

Worries over inflation and a desire to use policy tools beyond hiking interest rates are behind this, Bhandari said.

Today, the rupee rose to 40.53 per $1, a new high in nine years. Since January, it has gained 9 per cent to the dollar.

The RBI's absence in the foreign exchange market along with a weak dollar in global markets due to strengthening hopes of a cut in interest rates in the US as well as strong inflows from foreign funds and exporters have helped the rupee gain sharply.

But this situation could change, treasurers said.

"If the rupee starts breaking above 40, then RBI will intervene strongly," said Manish Wadhawan, director - treasury at HSBC.

"But there is a high possibility RBI will not let the rupee test above 40."

The RBI has allowed such a massive appreciation in the rupee as its intervention would boost liquidity and stoke inflationary pressures.

Inflation had touched a two-year high of 6.69 per cent in January, but ended 2006-07 (Apr-Mar) at 5.74 per cent, above RBI's target of 5.0-5.5 per cent.

The RBI has been fighting inflation by raising interest rates and tightening cash supply by mandating high cash reserves for banks.

For 2007-08, RBI is aiming at an inflation rate of close to 5.0 per cent. Another reason that might prompt RBI to act and intervene when the rupee tends to appreciate above 40 would be to limit the damage caused to Indian exports, treasurers said.

"40 is the key number, exporters are already crying," said Vikas Goel, executive director - treasury and money markets at Calyon Bank.

The government is aiming at 28 per cent export growth in 2007-08, but according to a survey by industry association Assocham, exports will grow only by 10-15 per cent in the current financial year.

"Right now the rise in the rupee is supportive of the policy as it helps in consolidating inflation gains," Goel said.

CRR vs MSS
In the event of the rupees being infused into banks following dollar buying by RBI, it would be inclined to first use the market stabilisation scheme (MSS) to drain liquidity and not resort to another hike in cash reserve ratio (CRR), the experts said.

"We had earlier expected a CRR hike in May. But now we think RBI will use MSS," said Goel.

"The enhancement of the MSS has been designed for that purpose and if the MSS is not successful, then one last hike in CRR is possible in June."

The RBI has raised the ceiling on MSS tenders for the current financial year to Rs 1,10,000 crore from Rs 95,000 crore earlier. The ceiling was Rs 80,000 crore prior to that.

"A CRR hike is postponed for the time-being," said Samiran Chakraborty, chief economist at ICICI Bank. "CRR hike will be needed only if there is strong intervention. If the intervention is moderate, then RBI will use the MSS."

Since December, the CRR has been hiked by 150 basis points to 6.50 per cent to keep liquidity balanced-to-tight.

"They have achieved mildly as regards deceleration in inflation and credit," said Wadhawan. "In terms of tightening, we think they will let the CRR remain till Sep-Oct depending on data that will come on money supply and inflation."

Wadhawan expects the RBI to announce a Rs 10,000 crore gilt issuance under the MSS by the end of this month to suck out the inflow of Rs 18,000 crore on maturity of gilts and coupon inflows.

"They might not touch rates and also keep liquidity in balance."