Jul 31, 2013

RBI's demolition of the Indian economy, in a futile, confused defence of the rupee

India faces an imminent macroeconomic crisis. The rupee has been rapidly depreciating, faster than most other emerging market currencies. A rapidly depreciating currency is unhealthy - foreign investors find it very risky to buy equity or debt in the face of significant currency risks.
Given the inelastic nature of India's import portfolio, and low elasticity exports to exchange rate depreciation, there is little hope of a meaningful improvement in the CAD. India is confronted with the reality of entering a death spiral where a depreciating rupee leads to a wider CAD which in turn fuels a further weaker rupee.

In the last fortnight, the RBI has taken several steps to support the rupee. It has raised the average daily CRR requirements to 99 per cent from 70 per cent during the fortnight. This effectively forces Indian banks to deposit approximate Rs 560 billion with the RBI to fulfill their statutory requirements.

Further, the RBI has capped the total amount of funds that an individual bank can repo at 7.25 per cent with the RBI at the Liquidity Adjustment Facility (LAF) window to 0.5 per cent of their Net Demand and Time Liabilities. This implies that the individual banks in shortage of liquidity to meet their now higher CRR can turn to the LAF only for limited relief.

The RBI also raised the spread between the Margin Standing Facility (MSF) rate and the repo rate effective for LAF form 100 bps to 300 bps, bringing the effective rate to 10.25 per cent. Banks, which ran into shortage of funds due to the higher CRR requirement, now have to borrow funds at 10.25 per cent from the MSF or from the overnight call money market. The RBI has achieved monetary tightening without raising the repo rates. Since the RBI announced these measures, overnight call rates from around 6 - 7 to about 10 per cent. Yield on the 10 year Government of India bond rose from 7.20 bps to about 8.5 bps.

Position limits in the domestic currency derivatives markets  were also drastically reduced forcing many brokers to go into liquidation only mode for rupee trades for both clients and proprietary positions. The margin requirements for onshore currency futures was also doubled thereby reducing the leverage in the currency markets by half. As a consequence, onshore trading volumes fell by 50%.

Both these measures reduced the pressure on the rupee. The monetary tightening created forced sellers of some domestic banks while the substantially lower position limits curbed domestic speculation on the rupee. The rupee appreciated by 2 to 3 per cent and it seemed that the RBI was serious about defending the currency. It was an opportune situation for the RBI to aggressively intervene in the USD/INR markets; this would have created panic amongst deferred buyers of dollars such as importers, corporate hedgers, and potential debt investors waiting for the currency to stabilize.   

These measures were also intended to target the offshore Non Deliverable Forwards (NDF) markets where the rupee forwards usually trade at a premium to the onshore markets. A very popular carry trade amongst particularly foreign banks and domestic banks with offshore trading operations was to sell the contracts in the offshore market and buy them cheaper onshore to earn an arbitrage profit. By reducing the position limits on the domestic exchanges and sapping domestic liquidity, RBI hoped to reduce the speculation on the NDF markets.

Unfortunately the RBI stopped short, and adopted a dovish tone. Subbarao reiterated that they are “concerned with exchange rate volatility, not rupee level”. Further, the central bank clarified they were “anxious to roll back liquidity tightening measures as anyone else but getting locked into a timeframe of rollback is not feasible due to the volatility in the forex market”. The rupee depreciated over 2 per cent in two trading sessions and came very close to its lows again.

There is an inherent contradiction in the RBI’s defense of the rupee. The RBI has been taking drastic steps to check the depreciation in the Rupee while maintaining that it is “targeting the volatility, not the levels” of the currency. Making such statements is a mistake. These leave the doors open to speculators to bet against the rupee as the implication is that the RBI does not care if the rupee goes to 60, 61, or 65! There is nothing that markets love more than an asset moving one way with low volatility. So speculators simply load in whenever the rupee appreciates a little. The RBI makes it an easy trade.

The economy will pay dearly for the monetary tightening in defence of the rupee. These measures came at a time when industry was looking to the RBI for relief, not higher rates. With the GDP growth already at the 5% handle, India simply cannot afford such cheap sacrifice of growth. Low growth begets weaker exchange rates. Depreciating rupee leads to higher fuel costs or subsidy bills, which by the RBI’s admission causes higher inflation. Higher inflation induces the RBI to keep interest rates high which continues to put downward pressure on growth. The cycle is vicious.

The present policy stance does precious little to promote currency stability. The RBI needs to decide whether it wants to defend the rupee or not. What it certainly should not do is make incessant, ineffective statements.

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