Deconstructing RBI's strategy

Measures to defend the rupee have created another set of problems

The measures announced by the Reserve Bank of India (RBI) to counter depreciation - a combination of a cap on repo or Liquidity Adjustment Facility (LAF) borrowings (the amount that banks can borrow from the RBI using government bonds as collateral) and an increase in the marginal standing facility rate (MSF, or the rate at which the RBI offers overnight money to banks in excess of their repo entitlement) from 8.25 to 10.25 - is likely to bring some stability to the currency market. However, they are likely to breed another set of problems that might be difficult to grapple with

At first glance, the measures might appear to be somewhat radical but are actually out of a textbook. For years, economics professors have exhorted their students (should they dabble in economic policy-making) to hike interest rates and squeeze liquidity if the currency comes under pressure. Higher interest rates make a country's bonds more attractive and invite capital inflows. A squeeze on liquidity also makes it more difficult to speculate against the currency. Tuesday's measures follow this advice in spirit, though the exact method is somewhat more circuitous.

The objective of the recent measures is to engineer a rise in yields particularly for shorter tenor bonds by increasing the marginal cost of liquidity. If the liquidity deficit is large enough, the overnight rate is likely to move towards the MSF rate of 10.25. As the overnight rate moves up, it will pull other yields up with it. Indian bonds and debt will regain their advantage vis-à-vis US treasury bonds (that have moved up recently on quantitative easing withdrawal fears) and the rout in the domestic bond markets driven the massive pullout by foreign institutional investors could stop. Tighter liquidity would also force punters to unwind their bets against the rupee The result - stability or appreciation for the rupee.

There is perhaps another less technical but equally important implication of these measures. By adopting these somewhat harsh measures, the RBI has signalled its discomfort with the rupee breaching the threshold of 60 to the dollar. It has also indicated that it is willing to pull out all the stops to "defend" this level. This "guidance" from the central bank could itself anchor the exchange rate at this level and even cause it to measures.

For the measures to work, the cap on repo borrowings has to be binding and the deficit in the LAF would have to be substantially larger than the levels of roughly Rs 70,000-90,000 crore that has been the deficit prevailing recently. My guess is that for this mechanism to work, the RBI would have to pull the deficit up to at least Rs 125,000 crore.

To ensure this deficit, the RBI has unveiled stage two of its strategy. Instead of buying back bonds from banks and infusing liquidity that it had been doing earlier, the central bank has started selling bonds to mop up liquidity. The first attempt to do this last Wednesday came a cropper with banks refusing to buy anything more than Rs 2,500 crore at yields that the central bank found reasonable. The monetary authority perhaps hopes to be luckier with the next round of sales.

There could be other measures to drain liquidity. The RBI could co-ordinate with the government to ensure that government spending (that infuses liquidity in the money markets) is restrained. This is incidentally is the "collection season" for the government (it gets dividends from public sector undertakings, the RBI and so on) and thus, it absorbs liquidity. If this absorption is not set off by infusion, the liquidity deficit could move up. Finally, if all else fails, the option of hiking the cash reserve ratio remains.

The economics students who have been exhorted to hike interest rates would also certainly be of the cliche that there is no free lunch in economics. Thus, the measures introduced to defend the rupee have triggered another set of problems that both the RBI and the government will have to grapple with.

To start with, the expectation of a liquidity squeeze led to a "mini-crisis" for the money market mutual funds who were left high and dry after banks and companies liquidated their holdings. This forced the RBI to open a special Rs 25,000-crore window for them to stave off an implosion. The bigger worry is the fate of the government borrowing programme. The benchmark 10-year bond yield has moved up by a hefty half a percentage point since these measures were announced. It could rise further if short-term rates start to climb on the back of falling liquidity. As government borrowing costs rise, it would increase the government's interest bill going forward and create yet another drag on the fisc. Tighter liquidity would also mean rising costs for banks that they could transmit to lending rates hurting growth in the process. The consensus among economists is that these measures alone will shave off between third to half of a percentage point from gross domestic product growth.

The bottom-line is that these measures will have to be temporary. The question is: when will the RBI be in a position to reverse these measures? A relatively prolonged period of stability for the currency could convince the RBI but there is no guarantee, given the global situation, that volatility will not return with a bang. Thus, the measures can perhaps only be lifted if the government manages to get a lumpy supply of dollars as well as create a buffer for intervention in the currency market. A sovereign or quasi-sovereign bond issue thus, seems imperative at this stage.

The author is with HDFC Bank.
These views are personal