External risks are weighing heavily on the RBI’s mind. The external shocks the RBI is worried about are of course relating to slide in the external value of the rupee. Volatility in the foreign exchange markets often becomes a cause for concern only when the underlying trend is downwards.

Even so, the rationale for liquidity curtailment and enhancing the cost of short-term credit remains unexplained, both in the measures announced in July and in the latest policy review.

Counter-PRODUCTIVE STEPS

Some of the measures initiated by the RBI that put restrictions on market operators may actually have made the markets narrow and, hence, more prone to instability. Immediately after mid-July measures were announced, the Centre was quick to announce that the RBI measures were aimed at curbing speculation in the forex markets, and that these measures were temporary and unlikely to affect interest rates offered or charged by commercial banks.

In its latest policy statement, the RBI has also indicated the unwinding of liquidity restriction measures in a calibrated fashion, once the forex markets become stable.

For the past several years, the RBI had desisted from intervening in the forex markets. What was the trigger for the RBI to change gear, increase cost of short-term funds and curtail the availability of liquidity adjustment facility?

It is true that exchange rate volatility, a euphemism for sharp depreciation of the rupee, would lead to higher burden on domestic borrowers of foreign currency funds (mainly private corporate sector) as also a possible increase in the inflation, as domestic prices of imported goods would increase.

STRANGE TRADE-OFF

But it is not clear whether the trade-off between instability arising from external shocks vis-à-vis depressed economic activity and investment climate due to higher interest rates is acceptable. The events in July also bring out importance of availability of funds. Even without increasing its policy rate, namely, repo rate, the RBI could generate a notable fall in prices of debt securities and the resultant increase in yield. The yield on 10-year government paper has increased by about 50 bps to 8.5 per cent. This was achieved by reducing the availability of liquidity adjustment facility drastically to 0.5 per cent of a bank’s deposit.

While interest rates charged/offered by public sector banks have not yet increased, how long these rates remain unaffected is a moot question. Already, a few private banks have increased short-term deposit rates and one of them has increased the base lending rate. If the RBI measures remain in force for a few weeks more, the cascading effect on bank deposits/loan rates would be inescapable.

With the increase in bond yields, the government’s borrowing programme has been affected. Recent issues have partly devolved on primary dealers as there were not sufficient investor bids at the yields offered by RBI.

In case the RBI accepts higher yields, it would be able to mop up the liquidity but inflict a higher cost for fresh borrowing by the Government. Thus, the measures designed to affect speculators in forex cannot remain limited to the forex market and will spill over into domestic borrowing and lending activity.

External shocks

When the RBI was trying to reduce interest rates through reduction in policy rates, its transmission to bank offered/charged interest rates was found to be very weak. But through July 2013 measures, without affecting the policy rates, the RBI has curtailed liquidity and the transmission to bonds market was instantaneous and vigorous, though the bank rates have not yet been impacted.

It would be unrealistic to expect that the RBI to announce a timetable indicating unwinding of liquidity curtailment measures. It is understandable that the recent bouts of rupee depreciation started from announced tapering of bond sale programme by the US Fed.

This truly is an external shock, but the internal macro factors (high CAD, high food inflation, low domestic investment) make the Indian economy more vulnerable to this threat.

Unless the forex markets are calmed, given the increase in bond yields, commercial banks may be hit hard, as nearly a quarter of their the balance sheets comprise bonds, mostly sovereign.

It is ironic that banks would be affected either way; through volatile forex markets (depreciating rupee) or volatile bond market (rising interest rates). In the first instance, the adverse effect would be indirect via weakened corporate loans turning NPAs, while in the second instance it would be direct, as their investment portfolio would stand depreciated.

(The author is Chief General Manager, IDBI.)

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