Uneven results of a rate cut

A sudden rise in crude oil prices, or a deeper slowdown in China or a recession in America could hurt

The rupee and, more generally, global currency markets are liable to see continuous volatility in the next six months to a year. The rupee's movement will be influenced by the following: First, there is strong consensus the Reserve Bank of India (RBI) will cut policy interest rates, perhaps tomorrow (June 2) itself. Second, RBI is buying foreign exchange in substantial quantities and will continue to do so. Third, the US Federal Reserve has issued an implicit warning that it is likely to raise dollar interest rates soon.

The timing of all this is uncertain. RBI might not cut tomorrow but will surely cut soon. Inflation is below target levels. Growth is weak in capital-intensive manufacturing industries. The real rate of interest over inflation is about 2.5 per cent or more, going by the spread of treasury yields over the Consumer Price Index. It is reasonable to assume RBI will cut rates substantially, in several tranches, over the next year.

On the forex front, the RBI has bought $100 billion in the past 12 months. It will keep buying while India experiences strong inflows. Foreign investments are good in themselves but rising inflows tend to cause currency appreciation.

A stronger rupee hurts export competitiveness, which has fallen through the past financial year. By April, exports had dropped in each of five successive months. A stronger rupee also hurts domestic manufacturers, which face competition from cheaper imports.

Buying forex controls rupee appreciation. High reserves are also useful insurance against high currency volatility. RBI buys forex (selling rupees), to keep the rupee down and build reserves. Then, it auctions treasury bills to pull the rupees out of circulation. So long as India continues to be a favoured destination for foreign investments, RBI will implement some variation of this sterilisation.

Finally, the US Fed might raise rates within the next six-nine months unless things go wrong. Overall, the US economy is recovering at a reasonable speed. The Fed is likely to hike dollar policy rates to prevent overheating, unless the US has a sudden recession or some crisis.

US treasury instruments (considered zero-risk) offer much lower yields than rupee treasury instruments (also considered low risk) of comparable tenure. It is tempting to borrow low interest dollars, convert to rupees, invest in rupee debt and then reverse transactions to book profits.

The risk is that the dollar will appreciate too much while this carry trade is live, wiping out gains on interest rate spreads. Foreign portfolio investors (FPIs) are not allowed to invest in short-tenure rupee treasuries, so this is a serious risk. Even so, FPIs have generally invested close to their permitted limits in government treasuries.

If the US raises policy rates and RBI cuts rates, the two yields will tend to converge. The carry trade mentioned above will become less attractive. In fact, the rupee (along with other currencies) has already come under some pressure in anticipation of a dollar hike.

But rupee-denominated assets gain in attractiveness due to other factors if there's a rupee rate cut. Indian equity becomes more attractive. It will attract higher forex inflows. Also, Indian treasuries (and corporate debt) will offer capital gains as rupee interest rates fall. That will lead to a churn in FPI rupee debt holdings. FPIs will book profits on their earlier high-yield treasury holdings and reinvest in newly-issued lower interest debt. These trends should define the currency markets over the next three or four quarters. Equity valuations in general should receive a boost, as interest rates fall. The financial sector and capital-intensive businesses will be bigger winners. And, of course, rate cuts might serve the primary purpose of helping the economy achieve a turnaround.

Ideally, the rupee should see gradual and controlled depreciation. There will be a sweet spot for the currency. That is a band where exports are competitive, while the import bill stays within acceptable limits. RBI will have to identify the band and keep the rupee within it. Rupee depreciation also implies long positions in dollar-rupee (and perhaps in other currencies, too) could be profitable.

Obviously, the consequences of a rate cut will be uneven. Some banks and businesses will do better than others. A sudden rise in the price of crude oil or a deeper, longer slowdown in China or a recession in America could derail this benign scenario. But there is good reason to hope for rate cuts allied to earnings acceleration in 2015-16.