Though it is early days yet on RBI’s efforts to stabilise the rupee—after closing at 59.77 on Tuesday when RBI tightened liquidity again, it ended Thursday 67 paise stronger—the government would do well not to be sanguine. For one, in the recent past, the impact of policy measures has typically dissipated over a few days. Second, though many like to draw a parallel with 1998 when RBI also tightened liquidity in response to a similar currency weakening—from an average of around 7% in Q4FY97, call rates even crossed 100% on a few days in January 1998—the situation today is quite different. The big difference is the $250 billion FII presence in the equity market—if the already sluggish economy is to further slow in response to the hike in interest rates, and some part of this money moves out, the rupee will be in trouble. So far, FIIs have responded well to the RBI measures. Though they withdrew $230 million on Wednesday, the withdrawals could be slowing—between July 1 and 15 when RBI first tightened liquidity, FIIs withdrew $2.5 billion from debt and equity markets; between July 16 and 24, they withdrew $602 million. But with bond yields rising dramatically, so much so that even the government had to borrow R5,000 crore at 10.649% (a 13-year high for 363-day paper) and R7,000 crore at 11.0031% for 91-day paper, the picture could well change if the liquidity squeeze is in place for too long.
The key to how long the squeeze will last—it lasted 4 months in 1998—depends on what happens to the rupee. And with the ratio of short-term foreign debt to total debt at 24.4%, India has a big financing problem given that, based on likely flows for FY14, there is a balance of payments gap of $20 billion that needs financing. While this would typically be made good by FIIs, this is under threat right now and, the way the rupee is going, even trade credit flows are likely to be lower. What is worrying is that despite the rupee looking shaky for 2 years, the government still hasn’t got