Will Raghuram Rajan revoke liquidity tightening measures?

RBI could consider revoking liquidity tightening if Fed defers taper as high rates haven't helped currency volatility

All eyes are on Raghram Rajan before his first monetary policy statement on 20 September.

While it is difficult to predict what he will do, the market would like him to reverse the liquidity tightening measures because it isn’t helping in taming India’s unwieldy current account deficit, which is driven by gold, oil and coal imports.

Demand for these commodities cannot be curbed through interest rates. So the big question that everyone is asking is: Will the Reserve Bank of India (RBI)’s newly minted governor revoke the liquidity tightening measures announced in July.

Even though a lot depends on the much feared Federal Reserve’s move to taper its bond buying programme on 18 September, markets would like to see some clarity on which way interest rates are headed.

It is becoming increasingly becoming clear that the rupee’s 28% fall between 30 April and 28 August has been largely caused by a crisis of confidence triggered by the selling by foreigners in the bond markets. Additionally, nearly $13 billion exited the country between July and August on account of hedging by corporates, which led to further volatility in the rupee.

Anand Shanbhag of Avendus Securities believes that high interest rates or prices don’t affect the demand for coal, gold or crude. In fact, the sources of funding in the capital account (portfolio flows, FDI and foreign loans) are affected by high interest rates. Going by these factors, there are chances of RBI revoking its tightening measures when the time is appropriate.

Much of what happened in August had to do with panic. Credit Suisse estimates that between July and August, nearly $13 billion exited through panicking corporates hedging themselves.

If the theory of panic is to be believed the rupee’s depreciation can reverse even faster, thus, rendering the liquidity tightening measures of July redundant. So be it from the point of view of a bloated current account deficit thanks to imports or rupee’s depreciation due to panicky outflows, there is little merit in continuing with the liquidity tightening measures.

A section of experts believe that the panic around currency’s volatility has been overdone. Once the RBI’s measures to offer swap lines to oil marketing companies (OMCs) and forex swaps for banks start yielding dollars by mid-November, central bank may be able to recoup its foreign currency reserves too, which would ease the pressure on balance of payments.

For the time being, RBI may continue with its tightening measures till December. However, if the Federal Reserve defers tapering of its bond buying programme, then things may take a different course.