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Business News/ Opinion / Online Views/  Has RBI given up on the rupee?
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Has RBI given up on the rupee?

After a series of half-hearted measures, a directionless central bank cannot afford to direct the market

Tightening of short-term rate was just a means to an end—the end being to arrest the fall of the rupee. If that has not happened, what was the logic behind the reversal of the stance? Photo: Bloomberg (Bloomberg)Premium
Tightening of short-term rate was just a means to an end—the end being to arrest the fall of the rupee. If that has not happened, what was the logic behind the reversal of the stance? Photo: Bloomberg
(Bloomberg)

There are two kinds of doctors. One sort diagnoses the ailment, prescribes medicines and waits for the patient to get better. The other prefers to experiment and, in the process, often ends up spending more time in dealing with the side effects of the drugs he has administered. In the end, the type II doctor gives up treating the patient altogether.

The Reserve Bank of India (RBI) seems to belong to the second category. Since June, it has tried an array of cures to try and arrest the fall of the rupee. Until last week, when it gave up.

First, RBI banned foreign institutional investors (FIIs) from accessing the currency derivatives market on behalf of their clients, unless “a clear mandate from the sub-account holder" is produced. It also restricted banks’ ability to take positions in the currency derivatives segment. And it asked banks not to do any proprietary trading in derivatives unless the purpose was to hedge on behalf of their clients.

But the rupee continued to fall. So in July, RBI targeted speculators who were supposedly punting on the currency. In the first round, it attempted draining liquidity from the banking system and make money more expensive.

It capped the amount that banks can borrow from its liquidity window at 1% of the deposits of the entire industry; raised the rate at which banks can borrow from RBI in excess of 1% of deposits by two percentage points; and tried sucking out liquidity from the system by buying bonds through the so-called open market operations (OMOs)—something it had not done in recent years.

When these measures too failed, it tightened liquidity further by reducing the limit of borrowing for individual banks at 0.5% of their deposits and raising the level of the portion of deposits, or cash reserve ratio (CRR), that they need to keep with RBI on a daily basis.

In August, the banking regulator continued its liquidity tightening measures by a different instrument—short-term cash management bills—and then resorted to partial capital control by limiting people’s ability to remit money overseas and corporations’ investments abroad. At the same time, it raised the rates that banks can offer on deposits of non-resident Indians, aiming to attract a great flow of money from abroad.

When all these measures failed to stem the volatility in the currency market (officially, RBI does not target any particular level of the rupee but it wants the market to be less volatile), the central bank gave the up fight on 20 August.

Just like a doctor fretting over the side effects of the drugs they prescribed, the central bank decided to address the sudden spurt in long-term bond yields, which affects the government as it will have to pay more to borrow from the market. RBI now launched the Indian version of the Fed’s Operation Twist—buying long-term bonds from the market to ease pressure on long-term yields and selling short-term cash management bills to keep rates at the shorter end firm.

While announcing the latest round of measures, RBI said a review of the liquidity tightening measures suggest that the “immediate objective of raising the short-term rates has substantially been achieved". Indeed, it has been achieved—if the objective of the measure was only tightening the short-term rates. But what about stemming the fall of the rupee?

Tightening of short-term rate was just a means to an end—the end being to arrest the fall of the rupee. If that has not happened, what was the logic behind the reversal of the stance? Has it been done just to save the government’s borrowing cost? Does this mean that RBI has realized that it cannot contain the rupee? Will it now allow the currency to find its own level? These and many more questions remain unanswered.

Meanwhile, the rupee rebounded against the dollar on Friday, ending a five-day streak of record lows, logging its biggest gain in a day since June last year but nobody is sure whether it has seen its bottom yet.

All these measures and partial reversal of RBI’s stance do not send the right signals to the market.

First, RBI wanted to tighten liquidity but, at the same time, was not prepared to accept that the rates would go up. So, it did not go ahead fully with the sale of bonds as the banks were demanding a higher yield. It even cancelled a treasury bill auction as here too the buyers were demanding higher yields.

By not selling treasury bills, it actually ended up infusing money in the system (as an old treasury bill sold earlier was redeemed) when its objective was to drain liquidity. RBI insiders say the reason behind its refusal to accept bids for the long-term bonds and treasury bill was that it was not ready to accept a sudden spike in interest rates. But the market has its own reasons and even though the regulator did not approve of its ways, the short-term interest rates first rose and then there was a spillover effect at the longer end and the 10-year bond yield crossed 9%, a level last seen in August 2008, and raced towards 10% on 20 August.

At that point, RBI realized that since it could not cure the disease, it must at least address the side effects—the rise in long-term rates. It decided to buy long-term bonds through an OMO. Apart from infusion of liquidity, such auctions also help RBI manage the bond yield. This also marks the beginning of a reversal of RBI’s liquidity tightening stance that was adopted to arrest the fall of the rupee. After a series of half-hearted measures, a directionless central bank cannot afford to direct the market.

Tamal Bandyopadhyay keeps a close eye on everything banking from his perch as Mint’s deputy managing editor in Mumbai. He is also the author of A Bank for the Buck, a book on HDFC Bank. Email your comments to bankerstrust@livemint.com

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Published: 23 Aug 2013, 04:59 PM IST
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