RBI’s recent measures to address exchange rate volatility

Something is going on.

Late last night, RBI announced some measures to address exchange rate volatility. Read that as to prevent rupee depreciation. Expectations are rife that Rupee will touch 70  by year-end. The expectations are based on the wide Current Account Deficit which so far has been financed by FII flows. As FIIs turn away, currency depreciation is the natural route. This means more of imported inflation and so on.

Fighting expectations is tough as it so happens that what is expected tomorrow happens much earlier as exp sets in. So we have some late night measures.

Foll. measures were taken:

  1. The Marginal Standing Facility (MSF) rate is recalibrated with immediate effect to be 300 basis points above the policy repo rate under the Liquidity Adjustment Facility (LAF). Consequently, the MSF rate will now be 10.25 per cent. Accordingly, the Bank Rate also stands adjusted to 10.25 per cent with immediate effect.
  2. The overall allocation of funds under the LAF will be limited to 1.0 per cent of the Net Demand and Time Liabilities (NDTL) of the banking system, reckoned as Rs.75,000 crore for this purpose. The allocation to individual banks will be made in proportion to their bids, subject to the overall ceiling. This change in LAF will come into effect from July 17, 2013.
  3. The Reserve Bank will conduct Open Market Sales of Government of India Securities of Rs.12,000 crore on July 18, 2013. Details of the securities included for the OMO sale auction will be announced through a separate press release tomorrow.

Some explanation:

  • The second & third measures tighten Rupee liquidity. Both LAF Borrowing and OMO Purchases leads to creation of liquidity. With a cap on LAF borrowing and OMO Sales (RBI sells G-sec and gets reserves), there will be much lesser Rupee liquidity. This is expected to curb volatility as there will be lesser INR-USD carry trade. People are selling INR and investing in Dollar. This is leading to depreciating pressure on Rupee and the idea is to curb it. 
  • As liquidity tightens, Banks have two options. One, borrow from MSF at Repo +100 bops or borrow from markets. Not anymore as MSF has been raised to Repo +300 bps. This is expected to lead to higher interest rates and make Indian interest rates more attractive for FIIs in debt markets. This could lead to more flows and support Rupee.

The measures support exchange rate but has lead to hardening of interest rates. Yields in bond markets have jumped by 30-35 bps since y’day closing and call rates have jumped by 200 bps or so. It will be interesting to see whether RBI persists with this new policy as it could see significant dent in credit offtake as well. It also implies the July 30 policy is likely to be a non-event.

Instead of increasing Repo, RBI has just tweaked its measures to get the same effect. It could not raise Repo as economy continues to suffer. Raising Repo would mean end of the rate easing cycle, a sure disaster for the ailing economy. People had already started talking of rate hikes in India (one and two) given Rupee depreciation and it has happened much sooner than expected.

It is really tough to being RBI right now. Earlier it was trying to balance the infusion of liquidity (to counter tight liquidity) with its tight mon policy (to counter inflation). Now it is balancing the opposite -tightening of liquidity with its easy policy. Growth continues to remain weak warranting an easy policy and inflation (CPI) surges warranting an end to the easy policy. On top of that currency troubles. RBI’s cupboard is brimming with problems with no easy answers…

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One Response to “RBI’s recent measures to address exchange rate volatility”

  1. santhoshi Says:

    I agree with all said here. But i am a bit scared about the FDI measures announced today. If the caps are really raised , then it will increase the foreign dependency. I get that the situation is tacky..but still increasing FDI caps even in defence seems like a dangerous move to me.

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