Given how the rupee has been steadily depreciating—6% since the last policy—most expect RBI to raise repo rates later this week. A classic interest-rate defence is supposed to work in two ways. First, higher local interest rates will attract debt flows. Second, it will slow the economy and, to that extent, imports will also slow and the CAD will slowly move into balance. While an interest-rate defence won’t work—indeed, it is likely to backfire—it needs to be kept in mind that the rupee has not depreciated merely because of the widening CAD but also because the dollar has strengthened on the back of the tightening by the US Fed; indeed all emerging market currencies have lost value against the dollar in the last few months.
To that extent, raising repo rates is no solution. It would also be interesting to see how RBI justifies more tightening to stabilise the rupee, given that its mandate now is to target inflation. While RBI analyses that a 1% depreciation results in a 15 bps change in inflation—and a 10% increase in prices of crude oil moves inflation by about 0.6%—most estimates suggest that, even with all this, inflation may undershoot the projections, at least in the near term. Raising repo rates right now is likely to be counter-productive.
For one, interest rates are already rising in the system; the yields are high, and banks are hiking loan rates because attracting deposits has been expensive. The money markets are becoming tight with a dozen banks effectively not doing any business and outflows of foreign money from the bond and equity markets.
In fact, there is a liquidity scare in the markets and anxiety that weaker non-bank lenders might find it hard to roll over short-term borrowings; even good ones might need to shell out more to do so. Under the circumstances, and also given how the economy seems to be growing in fits and starts, it might not be prudent to add to the pressure.
Indeed, as Sonal Varma, chief economist at Nomura, argues, the global evidence on interest rate hikes helping to stabilise currencies is mixed at best. Apart from the fact that a rate hike will hit equity flows that respond positively to a hike in growth expectations, she argues this will also hurt banks’ profits by pushing up costs at a time when borrowers have stressed balance sheets anyway.
Also, while part of the reason for an interest rate hike is to slow the economy, that is happening anyway—apart from a slowing in government expenditure over the rest of the year due to shortage in GST collections, NBFCs will find their resources crimped and this will slow household consumption. Consequently, growth capital—both locally and from overseas—will be limited and, in turn, could slow consumption and investment demand.
For the present, it might be better to hold the rate hike and ensure there is enough liquidity—RBI has said it will infuse liquidity via OMOs but as economists have pointed out, the quantum of OMOs required would be close to Rs 2 lakh crore; RBI has not promised such a high level of OMOs. Also, given the government’s attempts to conserve forex by hiking import duties, it is still not clear why it has not gone in for a $30-40 billion NRI bond so far.