Hike rates

The Rupee Challenge: RBI Doesn’t Need to Defend the Rupee and Should Only Raise Rates to the Extent Necessary to Tame Inflation

Given the appreciation of the dollar, continued capital outflows from stock markets and demand from importers, it is no surprise that the rupiah broke through the 80 mark against the greenback, albeit for a brief period. The Reserve Bank of India (RBI) has intervened in the currency markets to provide dollars, but only to a limited extent. This suggests that the central bank is not averse to currency depreciation and will not risk depleting its reserve pool, which has already fallen from $640 billion to around $580 billion.

RBI believes that the Rupee is properly valued and would not be uncomfortable with a depreciation of the Rupee to levels just beyond the 80 mark, given the global financial environment. Such levels are an obvious possibility, with the U.S. Fed expected to raise rates by at least 75 basis points, if not 100 basis points, later this month and more in the coming months as it battles against high inflation for four decades. This could then push the dollar index higher to levels of 111-112, causing emerging market (EM) currencies to fall further. If the dollar were to peak at these levels, the damage to emerging currencies, including the rupee, would not be severe. However, if the rupiah’s fall is exacerbated by a strengthening of the dollar index beyond 112, RBI may need to open the capital account further to attract dollar flows.

Indeed, the central bank has already taken the first steps by easing the rules to attract more FCNR(B) and NRE deposits and easing the rules on the rupee debt market to attract investment in the bond markets. Moreover, it allowed prime borrowers to raise more through External Commercial Borrowing (ECB). Admittedly, these measures may not immediately attract large flows; foreign portfolio investors (REITs), for example, will expect better visibility on both interest rates and currency. The central bank has also authorized invoicing, payments and settlement of exports and imports in rupees. Although this facility is widely used for trade between India and Russia, it would help save dollars.

The question is whether RBI will raise interest rate hikes just to defend the currency. Fortunately, domestic inflation appears to be at lower than expected levels and will likely peak in September. As a result, the quantum of repo rate hikes should now turn out to be lower than previously expected. The central bank should not try to defend the currency and should only raise rates to the extent necessary to control inflation.

A weaker rupee will make Indian exports more competitive; Above all, the economic recovery remains uneven, even fragile. With nearly half of the system’s loans tied to external referrals, transmission is rapid and rising interest rates could hurt small and medium-sized businesses. In the meantime, as overseas interest rates firm and liquidity dwindles, it will become more expensive, and somewhat more difficult, for Indian companies to refinance their foreign currency loans. But it is nothing impossible. Nevertheless, fears that refunds will be delayed or not made seem exaggerated. Certainly, a falling rupiah will mean a larger current account (CAD) deficit as imports become more expensive, because even though commodity prices decline, crude oil prices remain above $104/barrel. However, there is no need to panic. Foreign exchange reserves remain at a hefty $580 billion, and if the currency remains competitive against peer currencies, India’s exports should continue to do well, despite the global slowdown.