RBI likely to stay away from over-tightening

The Reserve Bank of India (RBI) would again have to strike a difficult balance in next week's policy review. Given the fact that the central bank has shown preference to tighten liquidity and push near-term interest rates higher, the probability of further monetary tightening next week might have increased at the margin. However, that isn't the central scenario in my range of expectations, as one foresees little benefit for such an action in supporting the rupee. Importantly, while growth-inflation dynamics continue to shape RBI's medium-term policy framework, curbing the rupee's volatility remains the immediate policy priority.

While the recent RBI moves have drained liquidity and pushed up near-term interest rates significantly, making forex speculation costlier, benefits for the rupee would likely remain limited. Had speculation been the key driver of the rupee's current weakness, the currency would have appreciated more after RBI's shock therapy. The rupee's rise against the dollar since mid-July had broadly been in line with a host of other currencies and the weakness in the broader dollar index. In fact, currently, an overdose of monetary tightening could turn counter-productive for the rupee, as it could potentially hurt FII (foreign institutional investor) flows into the equity market. FII investment in India is considerably higher in equities (about $200 billion in BSE500 companies) than in debt (about $30 billion); any over-tightening would likely be distinctly negative for the former, as it would further dent an already scrambling growth outlook.

Moreover, it might not necessarily boost bond investment either. The high cost of forex hedging and rising global interest rates have clearly made hedged FII investment in Indian bonds non-remunerative. On the other hand, un-hedged investment in Indian bonds by foreigners has turned considerably more risky, amid heightened volatility and a weakening bias for the rupee since early June. Accordingly, higher bond yields, despite the recent spike, wouldn't be enough to bring back FII investment in bonds, unless the rupee stabilises.

At the moment, policy focus on boosting more near-term forex flows would be the key to ensure strength for the rupee, rather than focusing on monetary tightening in isolation. That could arrest the negative sentiment against the rupee, win back part of the bond outflows (about $8 billion since mid-May), and meaningfully curb near term weakness in the rupee, offering much-needed breathing space to policymakers to address India's longer-term structural problems.

Siddhartha Sanyal

Chief India economist, Barclays