The consensus view on quarterly monetary policy review was no change in rates. So, there was hardly any surprise when the Reserve Bank of India (RBI) left these unchanged on July 30. What came as a big surprise, however, was the soft bias towards monetary policy and eagerness to roll back the liquidity measures for defending the currency. Market interpreted the "dovish" policy as lack of determination to defend the currency's level. The rupee promptly made a dash towards the previous high. It is now weaker by roughly three per cent against the dollar since the day of policy announcement. If it wasn't for RBI's intervention in spot market, it would probably have weakened a lot more.
Over the past couple of weeks, the rupee has weakened by 1.75 per cent and the market's measure of expected short-term volatility hasn't changed much. Does this mean the liquidity squeeze has not worked? Part of the problem lies in the fact that RBI has chosen orthodox tools which are used to defend currency's weakness whereas it has been trying to nuance its objective as of one of reducing speculation and volatility rather than defending a particular exchange rate level. The markets, on the other hand, have interpreted liquidity measures as exchange rate defence at 60 a dollar.
A similar approach is being used in the messaging around interest rates. Policymakers are trying to make sure the liquidity squeeze does not spill over to lending rates for real economy. Banks are being asked not to increase their lending rates even as the sharp increase in short-term rates has started impacting their funding costs and margins. A few banks already raised their deposit rates last week.
Given the rupee's trading behaviour during the last few days, the key question now is around next step from RBI. The bond market continues to fret about another round of monetary tightening and this time probably policy rates will have to be used. Even if policy rates per se are not hiked, the additional dose of liquidity medicine required will certainly cause long term rates to rise. In all likelihood, the liquidity squeeze will stay much longer than initially advertised. The impact will be felt on corporate balance sheets as funding costs rise. RBI, though, might wait for some time to see if the currency stabilises.
By announcing hard liquidity measures, the policymakers have effectively changed their stance to strong currency defense in the short-term. Interest rate policy has thus become subservient to exchange rate policy. It will not only be futile but also damaging to the credibility if this stance is to be abandoned prematurely and these measures are not followed through to their logical end, not withstanding the time involved.
The author is head, fixed income, Nomura
