India: Economy : RBI Focus Remains The Rupee

British Deputy High Commission Mumbai

July 2013



The RBI kept interest rates unchanged on 30 July as efforts to stabilise a depreciated rupee took precedence over supporting growth. The RBI’s statement explicitly mentions that the liquidity tightening measures it has put in place since mid-July are intended only to stabilise the currency and are short term. Unless we see a severe deterioration in external conditions and the rupee, the RBI is unlikely to raise benchmark interest rates.




The RBI made no rate changes at its meeting on 30 July, after calibrated measures over the past few weeks to push up short term interest rates and stabilise the rupee. The rupee had depreciated to an all time low, breaching the Rs60/US$ mark, as concerns of a taper in quantitative easing led to an exodus of foreign investment from emerging markets. The liquidity tightening measures were intended to push up domestic bond yields and stabilise foreign investment in bonds and the rupee. Bond yields have strengthened to 8%+ levels from around 7.5% earlier and the rupee recovered to below 60 levels. Interestingly, the RBI refused to accept bids at these higher yields in the open market sale of long term government bonds preannounced as part of its liquidity tightening package. A few days later it announced a sale of short term cash management bills on which it accepted higher yields.


This decision to keep interest rates on hold comes on the back of sluggish growth and moderation in WPI inflation. The RBI has cut its growth forecast for FY14 to 5.7% to 5.5%. The decision to tighten liquidity and keep interest rates on hold could deter banks from cutting lending rates. WPI inflation fell to 4.9% in June, but is likely to rise in the months ahead as the currency depreciation increases the cost of imported items such as oil. CPI inflation remains high at 9% on account of food prices, particularly cereals and vegetables. However, a good monsoon should provide some respite, particularly for cereal prices, in the months ahead.


For the moment, the RBI’s focus is on currency stability but growth and inflation are not entirely out of mind. The guidance said that the current situation would have provided a reasonable case for continuing its easing stance. However, India is now caught in a classic ‘impossible trinity’ trilemma: it cannot have free capital flows, an independent  monetary policy and a fixed exchange rate, all at the same time. Both the government and the RBI claim that they have no long term level in mind for the rupee. The RBI mentioned that the liquidity tightening measures, aimed at checking undue volatility in foreign exchange markets, will be rolled back in a calibrated manner. It reassured markets that it stands ready to use all available instruments at its command to respond proactively and swiftly to any adverse development.




Bond yields have softened and the rupee has weakened following the RBI decision, as some believe that the RBI has been more dovish than expected by explicitly committing to a roll back in the liquidity tightening measures. Others believe that the RBI has sent mixed signals. Equity markets declined over 1% on 30 July.  In general they have held up quite well amidst the volatility, although certain sectors, particularly banking, have suffered as tighter liquidity is expected to impact margins. 




The RBI has not entirely abandoned support for growth as is evident from its statement that liquidity tightening measures will be rolled back as stability is restored, enabling monetary policy to revert to supporting growth with continuing vigilance on inflation. The Central Bank has also exhorted the government to use the window of opportunity to bring the current account deficit down to sustainable levels.


The government has already announced some structural measures, increasing FDI limits and putting in place measures to curb gold imports. But the pressure on the rupee is expected to continue in the medium term. The government needs to address supply bottlenecks in areas like coal supply and iron ore mining to deliver a sustainable reduction in the deficit. A sustained recovery in developed markets will also help improve India’s external dynamics on the back of a recovery in exports.   In the interim, one solution being considered is raising capital through NRI or sovereign bonds.   


Governor Subbarao’s term comes to an end on 4th September, but the possibility of an extension cannot be ruled out. In any case, the status quo is likely to be maintained. The RBI is unlikely to raise benchmark interest rates unless there is a severe deterioration in external conditions and the rupee. That said, with the rupee fragile and inflationary pressures likely to re-emerge following the depreciation, the RBI will not be in a hurry to cut rates either.



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