Are RBI's measures to save the rupee enough?

Measures will widen gap between US and Indian bond yields, but won't defend the rupee for long

By sucking out liquidity from the system and increasing the cost of funds, the Reserve Bank of India (RBI) has taken the most painful route to support a wobbly rupee. The currency went into a tailspin after Federal Reserve Chairman Ben Bernanke indicated on June 19 that the quantitative easing programme could be tapered later in the year. Any tapering in liquidity by the US Fed on improved prospects would mean a reversal of dollar inflows from emerging economies like India. Soon after the speech, bond yields in the US started rising, narrowing the rate differential with India, which triggered a sell-off by foreign investors. This sent RBI scrambling as a large portion of India's current account deficit (CAD) is funded through erratic portfolio flows.

Over the past couple of years, India's CAD has risen very sharply to average at $80 billion a year. In FY13, the CAD rose to $88 billion, which is a far cry from $38.82 billion in FY10. This gap has been funded by erratic portfolio flows and relatively stable flows such as foreign direct investment (FDI), trade credits, non-resident Indian deposits and external commercial borrowings. While the stable flows are averaging close to $50 billion annually, nearly $25 billion of this CAD is funded through foreign institutional investor (FII) flows. Nearly 32 per cent of the CAD was financed through FII inflows in FY13, says Kruti Shah of Karvy Stock Broking. The $5-billion withdrawal by FIIs from debt and $2 billion inflows into equity justify RBI's desperate tightening measures.

By tightening liquidity, RBI has managed to push up bond yields to over eight per cent levels. This would make the interest differential between India and the US attractive again. However, this tightening will squeeze growth, as less money will be available to productive sectors. In a pre-election year, the RBI has chosen to take a path that will squeeze economic growth and consequently the current account deficit, too. With import cover halving to seven months, RBI did not have the luxury of intervening in the forex markets to sell dollars, so this is a commendable move by the central bank. However, senior currency analyst Sacha Tihanyi of Scotiabank believes the impact of RBI's measure would be of a temporary nature in the forex market.

Economists keep reiterating options such as issuing sovereign bonds either directly or indirectly through a government-backed entity. Bank of America Merrill Lynch believes that reissuing five-year forex-denominated non-resident Indian bond (at seven-nine per cent) could fetch about $20 billion. Also, there is no clarity on how gold imports will behave. While they have declined in June, the real test month will be September, which is when gold sales pick up. The real solution is to increase stable flows from FDI and trade credits to $60-65 billion, if the currency crisis has to be resolved.