Expected action, unexpected response

Written by Samiran Chakraborty | Updated: Jul 31 2013, 20:15pm hrs
No change in the monetary policy is in line with market expectations, but the currency markets responded negatively to the guidance and other comments around it. Reserve Bank of India (RBI) explicitly acknowledged that it would have continued with easy monetary policy if the currency had not depreciated and there is room for monetary policy easing once stability returns to the currency market.

Although RBI opted for a more balanced stance between arresting currency depreciation and supporting growth, the currency market was probably disappointed by this dilution of intent. Following a strong action taken by RBI in the last two weeks, many in the market believed that the RBI was extremely serious about stemming further currency depreciation the proverbial line in the sand approach. The emphasis was on managing currency volatility and not on defending a particular level on the rupee. This prompted the markets to think the RBI will let the currency to fall if conditions warrant, and in the absence of any specific measures to address structural current account (C/A) deficit concerns, the rupee lost close to 1.75% in the day and the equity and bond markets also fell in sympathy. The sharp depreciation not only poses questions about the effectiveness of the recent measures but also increases speculation about further tightening.

We agree with RBI that recent measures to support the rupee will, at best, provide breathing space for the government to take steps to reduce the current account deficit in a relatively calm market situation. In fact, in the policy statement, RBI pressed the government to take urgent action, without which it cannot help the rupee on a sustained basis. Import duty hikes for some non-essential imports will be an option but we believe more measures to attract stable capital flows will be important to check external sector imbalances.

Debt inflows encouraged by the higher interest-rate differential are likely to be volatile and equity inflows are likely to be muted, given the backdrop of Fed tapering fears and slower growth as a result of higher interest rates. Policy makers will have to speed up their decision to issue a sovereign/quasi-sovereign bond to convince the markets that the C/A deficit can be funded comfortably. The timing and actual instrument are still undecided as the RBI governor indicated that it might not be the right time to issue a sovereign bond.

It looks likely that the current stance will be maintained until at least the end of September. The RBI will want to assess the market impact of any potential QE tapering announcement that may come in mid-September. This could cushion the impact of any disorderly capital flight. Also, it would give policy makers sufficient time to consider further structural measures to address the C/A deficit and its funding. In any event, a reversal of the RBIs monetary tightening measures will be difficult because of the risk of sudden debt outflows following such a move. A calibrated exit strategy starting in October would mean that there are downside risks to growth from a lengthy period of monetary tightening.

The writer is managing director and regional head of research, South Asia, Standard Chartered Bank