Crying Rupee Flashcards
The rupee this week slumped past 68 to a US dollar for the first time since January 2017. The yield on the benchmark 10-year Indian government bond hit a three-year high on Tuesday. What is common to India, Indonesia and the Philippines is that each country has a
**fiscal deficit( we are borrowing more than we are lending) as well as
a **current account deficit ( We are importing more than we’re exporting) , or the twin deficit problem.
The Reserve Bank of India (RBI) needs to be applauded for its conservatism. It pushed back severe pressures to slash interest rates last year. It also attracted many critics by assiduously building foreign exchange reserves as a buffer against the next global shock. That realism should serve India well in the months ahead, especially if the fiscal numbers deteriorate while higher oil prices put the external account under pressure.
What should the Indian central bank do now? Its responses on three fronts will need to be watched.
**First to heightened inflation risks.
**Second, market intervention by the Indian central bank to stabilize the value of the rupee.
**Third, the liquidity management needed to keep government borrowing costs under control.
The rise in domestic bond yields ( bond yield rises to compensate for the loss in the purchasing power due to the high inflation rates )partly reflects this change in inflation expectations in the financial markets.
Any central bank facing higher inflation as well as a weakening currency would find it hard to not raise interest rates.
The RBI has already spent some $8 billion from its foreign exchange reserves over the past month to ease the decline in the rupee. (By selling dollars , the RBI is increasing the supply of dollars in the global market which is going to increase the value of the falling rupee)
Even while it remains to be seen if more foreign exchange will have to be sold to defend the Indian currency, it is now quite clear that the massive dollar buying to prevent rupee appreciation is a thing of the past. The RBI will now have to put those accumulated dollars to work in case there is more severe pressure on the rupee.
Bond yields have hardened owing to inflation fears, fears of higher government borrowing, risk aversion in banks and a general tightening in the money market because of dollar sales by the central bank. The RBI is due to buy domestic bonds through open market operations (OMO) today, in a bid to ease some of the pressure on yields. A more fundamental challenge will be to ensure that reserve money growth keeps durable liquidity in the economy on track. More OMOs—a form of quantitative easing—will be needed, since dollar buying is likely to be much lower than last year. Estimates vary between Rs1 trillion and Rs1.5 trillion.
The RBI has to fight on three fronts right now—inflation, exchange rates and bond yields—though the nominal anchor of its monetary policy is consumer price inflation*. Effective communication will be needed to ensure that the financial markets do not get confused about this policy triad.
The Indian central bank has done well in the past two years to not let its guard down, despite immense outside pressure. India is in a far better place than it was five years ago to deal with a global shock, but there are macro risks on the horizon. The big question now is whether the Narendra Modi government will continue to stick to its fiscal conservatism or succumb to temptation in the months leading to the next general election.
