Utter confusion and chaos have gripped the Indian money market over the past one week. There could be two explanations for this. One, the Reserve Bank of India (RBI) does not know what it wants and, two, it’s well aware of what it wants but the government does not want the central bank to have its way.
A week back, RBI capped banks’ borrowing from its repo window (at 7.25%) at Rs.75,000 crore a day and raised its marginal standing facility rate (MSF) and bank rate by 2 percentage points each to 10.25%. On top of that, it also announced Rs.12,000 crore of bond-selling under the so-called open market operations (OMO). Presumably, these measures were aimed at squeezing out liquidity from the system and making money more expensive. The idea was not to allow banks to use the rupee liquidity to punt on the dollar and put pressure on the local currency. The rupee hit its lifetime low of 61.21 per dollar on 8 July.
Has RBI achieved its goal? The rupee closed at 59.89 a dollar on 15 July, the day RBI announced these measures. After trading at around the same level for most of the week, on 19 July, the last trading day of the week, the rupee closed at 59.35 per dollar after RBI reportedly sold dollars in the market. A 54 paise gain over a week through these measures reminds me of the Confucian saying about using a cannon to kill a mosquito.
The measures have failed because everybody and anybody in the government, including Prime Minister Manmohan Singh, over the past week, harped on one thing—they are temporary. Their repeated assurance to the market killed the shock value of the measures—the key to the effectiveness of any central bank step.
The rupee depreciation has not been driven by speculators. When the nation’s balance sheet has a big hole in the form of a record high current account deficit, and economic growth is slowing, the local currency is bound to weaken.
Ideally, the liquidity tightening measures should encourage exporters to bring back their export proceeds—dollars—without delay and importers should not rush to buy dollars as both should feel the worst is over for the currency. Both help the currency find stability. But the moment every policymaker shouts from the rooftop saying the measures are temporary, their effectiveness vanishes. The exporters know that the rupee will weaken further once the measures are rolled back and so, why will they sell now as they can earn a few bucks more if they wait for a few weeks. Similarly, importers’ approach will be not to wait and buy dollars now as the greenback can get more expensive.
RBI, it seems, wants to have the best of the both worlds. It wants to tighten liquidity but does not want interest rates to go up. This is the most absurd part of the Indian central bank’s policy measures that unfolded last week.
To drain liquidity from the system, it had planned a Rs.12,000 crore bond sale through OMO but could only sell bonds worth Rs.2,532 crore on Thursday. The buyers wanted a higher rate but RBI was not willing to concede that. If indeed the measures are short term, why did RBI want to sell long-term bonds through OMO?
Since it did not want to accept the fact that interest rates must go up when there is less money in the system, it could not entirely sell the state loan that was also scheduled last week. It even cancelled the Rs.12,000 crore treasury bill auction. Finally, there were not too many takers for the Rs.15,000 regular bond auction, too, but the primary dealers, the underwriters for such auctions, came to the rescue of the auction. They bought little more than Rs.3,500 crore worth of bonds. Before the auction, RBI had jacked up their commissions many times.
One cannot have tight liquidity and easy interest rates but RBI wants that as it does not want the government to pay higher interest rates for its market borrowings. In order to ensure that the market rates do not rise, it refused to accept higher bids at the auction of bonds and cancelled the treasury bill auction. By cancelling the treasury bill auction, it actually infused Rs.12,000 crore liquidity in the system as typically, these short-term bills get rolled over once they mature.
There is no method in RBI’s madness. Since the liquidity was not drained, the overnight call money market remained soft last week. So, the 15 July late evening measures could neither make any substantial difference to the local currency market nor could tighten liquidity. They have failed.
This cannot continue. For instance, the government will need money and so RBI will not be able to cancel the next treasury bill auction. It needs to see through the government’s record Rs.5.79 trillion borrowing in the fiscal, of which Rs.2.1 trillion has been raised so far. The government plans to borrow Rs.3.49 trillion in the first-half of fiscal year, ending September.
If RBI is serious about tightening liquidity, it must accept market forces and allow interest rates to find their own level. If it keeps on cancelling auctions and/or rejecting higher bids, it can manage to keep the interest rate at an artificially low level, but there will be plenty of liquidity in the system, making a mockery of its measures.
One presumes that government pressure to keep the cost of market borrowing low is behind the RBI’s half- hearted approach. It should probably junk these measures and go for a hike in banks’ cash reserve ratio (CRR) or the portion of deposits that commercial banks need to keep with the central bank to tighten liquidity and make money more expensive in a more meaningful way. That is, if RBI cares for its credibility. Otherwise, its actions will continue to negate its own measures.
Banker’s Trust Realtime is a frequent blog by Tamal Bandyopadhyay, who writes a popular weekly column Banker’s Trust.