On Tuesday, the Reserve Bank of India sought to reinforce last week’s package of measures curbing liquidity in order to check speculation in the currency markets. In beefing up an already rigorous package so soon, the RBI is sending the message that it will pull out all stops to defend the rupee from falling below Rs.60 a dollar, which, according to market consensus, is the target level. The rupee, which fell to an all-time low of 61.20 on July 8, has since recovered to trade above Rs.60, but the danger of a slide back remains. Great significance is attached to the fact that the RBI’s recent package has not supplanted its more conventional intervention strategy of selling dollars by drawing down reserves. So far, some $5 billion to $6 billion dollars seem to have been expended and quite obviously, reserves cannot be run down indefinitely to support the rupee. But last week’s surprise announcement caught the markets off-guard. Though unconventional and certainly out of the ordinary in the Indian context, the RBI’s action follows the classic textbook approach to countering depreciation of the home currency by hiking interest rates and squeezing liquidity. Higher interest rates make domestic bonds more attractive and invite capital flows while the liquidity squeeze targets speculators.
The package has included a cap on short-term borrowings at the repo rate (the amount banks borrow from the RBI using government bonds as collateral) and a sharp hike in the marginal standing facility rate (which is a non-collateralised overnight borrowing facility available to banks). These will be further backed by bond sales to suck out liquidity. Obviously these measures come at a price. Higher bond yields — an intended consequence of RBI action — do not augur well for the government’s borrowing programme. A higher interest bill will impact fiscal consolidation. Tight liquidity will percolate to the banking system and that is certainly not good news for GDP growth. Money market mutual funds came under pressure as large institutional investors and banks dumped their holdings and the RBI had to open a special Rs.25000 crore window for them. Recent auctions of government paper did not elicit the right response from a majority of banks that were expecting a more attractive price. These and other deleterious consequences suggest that the RBI might withdraw its measures sooner rather than later. However, currency markets are unlikely to remain stable for a reasonable period of time. While the government and the RBI will step up their efforts to increase dollar inflows, there is perhaps no alternative for the RBI but to maintain a hawkish stance in its forthcoming credit policy statement.