India may score over other emerging market currencies in this year but matters are now getting complicated. Foreign portfolio investors (FPIs), who in October scrambled to purchase government bonds following increased caps, turned net sellers again last month (-$1.7 billion overall) as in May-September. Selling has persisted in December so far, seeming to gather pace although it’s too early to tell. However, a traditional December sell-off is usually observed as positions are often squared at year end. And the expected tightening in US monetary policy when it’s central bank meets on 15-16 December may further accelerate capital outflow.

Conflicts between monetary and exchange rate management have already surfaced in recent months but are now increased to the point that the central bank was compelled to announce open market operations, or sovereign bond purchases, to douse yields. A preview was seen last Friday when the rupee fell to 67 a dollar, before intervention support shored up the currency. Depreciation pressures and intervention support further squeezed domestic rupee liquidity, already in deficit for last two months for other, additional reasons, such as slower government spending and higher festival demand for funds.

Interest rates have inched higher across the spectrum after September, when the RBI lowered its policy rate by 50 basis points. Short-term rates are about 25bps higher, including those on 3-month commercial papers where companies were flocking to borrow. Long-term borrowing costs have risen sharply too. The 10-year bond yield, the pricing benchmark for bank loan rates, was 25bps higher at 7.79% at the end-November, the same as in August. In the primary market, the auction cut-off yield was 7.83% on 27 November, even higher than the 7.72% yields at the previous auction on 20 November. The more accommodative monetary policy stance thus stands invalidated by these developments.

The 7 December open market purchases are aimed at curbing short-term rates and keeping these consistent with the monetary policy stance. However, the shrinkage in net foreign currency assets is expected to persist as more capital outflow is likely ahead of the US Federal Reserve’s mid-December review, while temporary demand for funds is higher from tax payment outflows and consumer spending. Looking at the extent of the deficit and the currency support that might be needed ahead, markets now expect the RBI will continue such infusions right till the end of the financial year.

The conflicts arise just when the RBI guided at its 1 December monetary review that the central bank would use the space for further accommodation, when available, indicating more future easing. But the confluence of external and domestic factors is sharpening the delicate balance between need to avert currency depreciation and keep funding costs low as well.

Renu Kohli is a New Delhi based macroeconomist.