As an inflation-targeting central bank, governors and deputy governors have repeatedly maintained that interest rates will be used only to target inflation. Yet dealers today are wondering if the rupee will become a reason for RBI to front-load rate hikes, given the consistent fall in the Indian unit to fresh all-time lows, practically every day since mid-June.
The question in the headline has repeatedly been answered by successive Reserve Bank of India (RBI) governors, including Shaktikanta Das with a resounding "No". As an inflation-targeting central bank, governors and deputy governors have repeatedly maintained that interest rates will be used only to target inflation. Yet dealers today are wondering if the rupee will become a reason for RBI to front-load rate hikes, given the consistent fall in the Indian unit to fresh all-time lows, practically every day since mid-June.
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Evidence of this sentiment is the movement of the yield on the ten-year government bond, this week. This yield slipped from 7.39 percent at the closing on Tuesday to a low of 7.33 percent on Wednesday, reacting to the softer-than-expected 7.01 percent in June Consumer Price Index (CPI) which came after market hours on Tuesday. But from these lows, the yield climbed to a high of 7.4 percent on Thursday and then 7.44 percent on Friday reacting to the red hot US CPI of 9.1 percent which came on Wednesday evening.
The rise in yields was explained by dealers as a reaction to the fed fund futures which began pricing in a higher likelihood of a 100 basis point hike by the US Fed at the upcoming Federal Open Market Committee (FOMC) meeting on July 26-27.
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Explaining the market's fears, B Prasanna, head of treasury at ICICI Bank pointed out that, after the August 4 meeting of the Monetary Policy Committee (MPC) and by the time they meet again in October "the Fed would have probably hiked 150 basis points either as two 75 basis points instalments or maybe 100 and 50. And so even if RBI hikes by 50 bps (in August), you're still actually lagging behind the Fed. The interest rate differentials are going to come down and if they come down the forward premia is going to come down. And if the forward premia come down, it's actually ironically, discouraging exporters to sell (dollars) which doesn't create enough of demand for the INR," Prasanna said. He, however, caveated saying he doesn't expect a higher terminal repo rate because of the rupee. He only expects the RBI will front load the rates.
Yet another dealer pointed out that the RBI by allowing a rise in rates offered on Foreign Currency Non-Resident (Bank) (FCNR(B)) deposits, was already deploying the interest rate tool to the aid of the rupee. Others pointed to the chorus of rate hikes around the world, including in Asian EMs. In the past week central banks of Korea, New Zealand, Canada, the Philippines and the Monetary Authority of Singapore raised rates - in several cases, unexpectedly and in most cases, by more than expected. The rate hikes were between 50-100 bps. A veteran head of treasury at a large foreign bank pointed out that in this chorus, a 25 bps hike will make the RBI sound like a dovish outlier and could invite speculative shorting of the rupee by foreign funds.
An equal number of respected experts reject this argument. Neeraj Gambhir of Axis Bank pointed out that India's inflation is lower than that of the US; moreover, India's June inflation at 7.01 percent is much less above the RBI's target of two to six percent than the US CPI, which at 9.1 percent, is 700 basis points above the Fed's target of two percent. By no means does India need to mimic the Fed, he argued.
Anant Narayan, professor of finance at S. P. Jain Institute of Management and Research (SPJIMR), echoed this point. "I think we are far away from a situation like that. For one, the rupee continues to be overvalued by almost any metric that you look at. So if anything, you should be allowing the rupee to depreciate a little bit" and use the plentiful reserves to control the pace of depreciation, he said. "The only time you would contemplate a monetary side to currency defence would be in the extreme where the rupee has completely swung to the other side and you are short of reserves," he added. "That's not envisaged in our MPC mandate, nor should it even be thought about right now".
Anant addresses a crucial point. The MPC is the rate-setting body, not the RBI. And the MPC has no jurisdiction over or responsibility for the rupee. It has to deliver a CPI under six percent and it can use the repo rate for this purpose only. Right now the RBI may not have a problem raising rates because it needs to bring inflation to four percent. A theoretical dilemma emerges only when inflation is well behaved but a rate hike is warranted to arrest a falling rupee.
The markets are at the moment not worried about this theoretical nicety. Their fear is about the impending narrowing of rates between India and the US. Kaushik Das, an economist at Deutsche India pointed out that already the difference between India's repo rate and the Fed rate is low. If the Fed went for a 150 bps hike over the next two months, and the RBI does only 25 bps in August, the difference between Indian and Fed rates will narrow to less than 200 bps, which would be the lowest in history. "You need to keep that in mind that you cannot be oblivious of the interest rate differential," he said.
The interest rate differential argument is a thin one, said another central banker. "Which interest differential," he asked. “Between dollar and rupee? Between yen and rupee? Pound and rupee?” His point was the actual differential doesn’t impact flows, but market sentiment does. So RBI will have to play it by the ear. If the currency markets are in tumult and there is an irrational scare, the RBI may have to use whatever it takes including the interest rate tool, if the cost of not doing so is high.
Currently, RBI is managing the rupee fall well with a mix of selling from its reserves and intervening in the forward market. But global waters are treacherous and sentiment can change on a dime.
In early August when the MPC meets, the Fed May have just done its first 100bps hike. Many economists are already expecting a 50 bps hike from the RBI on August 4, and the market chorus may grow louder closer to time. If it does, RBI may have to respond with a 50-60 bps hike taking the repo to around 5.5 percent.
First Published: Jul 16, 2022 6:48 PM IST