The de facto first quarter monetary policy measures this year were unveiled earlier than the official date, prompted by an urgent need to contain volatility in the currency market. Mid-July, the RBI, using the classic interest rate defence approach to contain speculative elements in currency trade, announced a slew of measures to tighten money market liquidity. While the measures led to the intended outcome, viz. hardening of money market rates, the markets continued to seek some guidance from the RBI on longevity of these measures.
In line with expectations, the first quarter monetary policy maintained status quo on key policy rates and attempted to provide a rationale for its measures taken earlier. In terms of communicating the timing of a rollback, RBI chose to link the reversal of the recent tightening measures to stability in the foreign exchange market, unlike the Fed, which provided a quantitative guidance to roll back QE-3. In the absence of any quantitative guidance here, the interpretation of foreign exchange market stability may vary and, thus, could leave markets in a constantly guessing mode.
Although the domestic liquidity tightening measures are intended to curb exchange rate speculation, we believe the rupee may also continue to react to announcement effects of Fed and crude oil prices. This, along with continuing weakness in CAD, will keep rupee on a weaker turf.
It is imperative that government intensifies its efforts to contain CAD through structural and administrative measures like steeper hikes in administered fuel prices, raising import duties on discretionary consumption items and reducing dependence on imported coal, among others. Absence of a lead role by the government could compel RBI to delay the reversal of the recent tightening measures. A prolonged continuation of such measures could prove detrimental to recovery in growth and in turn to domestic financial stability.
Meanwhile, it is important to ensure that the concerns on funding of CAD are mitigated by exploring options like issuance of NRI bonds. Stable and lumpy inflows from NRIs would shore up foreign exchange reserves and allow time for the government to initiate structural reforms to impart