US Fed’s Dec signal to keep fund flows muted

US Fed’s Dec signal to keep fund flows muted
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First Published: Fri, Nov 02 2007. 01 07 AM IST

Updated: Fri, Nov 02 2007. 01 07 AM IST
Mumbai: The US Federal Open Market Committee’s (FOMC) decision to lower its target for the Federal funds rate by 25 basis points to 4.5% will make Reserve Bank of India (RBI) governor Yaga Venugopal Reddy’s job somewhat difficult in the coming days. Still, Reddy shouldn’t have too much to complain as the Fed virtually ruled out another rate cut in December, and to that extent, the capital inflows into India are likely to be muted.
The widening of the gap between US and Indian rates will indeed put pressure on the rupee to strengthen, but economists and bankers do not expect Reddy to act in haste to bridge the interest rate differential.
NOT IN SYNC (Graphic)
RBI’s intervention in the foreign exchange market will, however, continue to protect exporters’ earnings in rupee terms. The rupee closed at 39.32/33 to a dollar on Thursday, off a peak of 39.22 hit in early trades, its strongest since March 1998. Heavy RBI intervention capped the appreciation of the local currency.
“I expect the rupee to settle at 38.5 to a dollar by March,” said Sanjit Singh, vice-president of ICICI Securities Ltd, which buys and sells government bonds. Singh said he expects RBI to tighten its monetary policy going forward, despite the cut in US rates. “When the economy is growing at over 9% and money supply is growing over 21%, one cannot expect the central bank to go for an easy money policy,” he added.
Historically, there is no correlation between the movement of interest rates in the US and India. In May 2004, the Fed rate was ruling at 1%, its lowest in many decades.
Unlike in the US, there are two policy rates in India—reverse repo, or the rate at which RBI sucks out liquidity from the system, and repo, or the rate at which RBI injects liquidity into the system.
In a liquidity surplus situation, such as now, the reverse repo rate is the policy rate and in a liquidity-starved situation, the repo rate is the policy rate. In May 2004, both rates were ruling at their historic lows—reverse repo rate at 4.5% and repo rate at 6%.
From that point onwards, the Indian policy rate was raised by 25 basis points (bps) for every 75bps or 1 percentage point hike in the US rate.
For instance, the reverse repo rate was raised by 25bps to 4.75% in October 2004 to catch up with the 75bps hike in the Fed rate to 1.75%. Similarly, the Indian policy rate was hiked by another 25bps to 5% in April 2005 when the Fed rate was ruling at 2.75%. Another 25bps hike in India’s policy rate took place when the Fed rate was up a full 1 percentage point to 3.75% in October 2005.
Overall, the Fed rate rose 425bps—from 1% to 5.25%— between June 2004 and June 2006. The pace of rise in the Indian policy rate during this time was much slower—only 125bps, from 4.5% to 5.75%. Later, the reverse repo rate rose to 6% and the repo rate went all the way to 7.75% while the Fed rate stayed put at 5.25% since June 2006.
So, it is highly unlikely that RBI will change its track and start cutting rates to be in sync with the Fed trajectory, particularly now when the US central bank has ruled out the possibility of a future rate cut.
Singh of ICICI Securities is not alone in predicting that RBI will tighten its policy in the coming months. Shuchita Mehta, senior economist at Standard Chartered Bank, expects RBI to tighten the reverse repo rate by 25bps in the first quarter of 2008 to 6.25%. Robert Prior-Wandesforde, an economist with HSBC, expects a 50bps hike in banks’ cash reserve ratio (CRR) and two more hikes in the repo rate.
Rohini Malkani, an economist with Citigroup India, expects RBI to continue to hike banks’ CRR in the coming months if the surge in dollar inflows continue.
To complicate matters for RBI, crude oil prices crossed a record $96 (Rs3,773) per barrel on Thursday, against $82.38 when the US Fed had cut its rate by 50bps to 5.75% on 18 September.
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First Published: Fri, Nov 02 2007. 01 07 AM IST
More Topics: Rupee | Dollar | RBI | Export | Federal Reserve |