Raghuram Rajan and the rupee

September 12, 2013

(Any opinions expressed here are those of the author and not of Thomson Reuters)

With Raghuram Rajan taking over as the governor of the Reserve Bank of India (RBI), it’ll make for a change in the central bank’s policy perception.

His predecessor Duvvuri Subbarao used conventional methods and got no results. It is likely Rajan will opt for innovative means and his initial steps are already showing results. It’s evident that the complex problems of today demand out-of-the-box solutions.

The rupee, beaten down by inflation and tortured by the current account deficit, had become weaker over the years. It got worse when the U.S. Federal Reserve announced tapering of quantitative easing that would have reduced (if not reversed) FII investment and made it difficult to fund the current account deficit.

When the rupee crossed 60 to the dollar and showed no signs of steadying, the RBI responded with its traditional method of squeezing liquidity to check speculation. It then tried to reduce the outflow of dollars due to overseas investments by Indian companies and individuals spending abroad. The result was a further slide, taking the rupee close to life lows of 70 to the dollar. That’s conventional wisdom for you.

Rajan wasted no time in his bid to rescue the rupee. The immediate need was to find dollars that would fund the current account deficit. He saw the potential that was left with commercial banks to borrow from the international financial market and made it attractive for them to tap it profitably. The final solution is to substantially reduce the current account deficit, if not eliminate it altogether, something which is not possible for the RBI alone to realize without government intervention.

The RBI has announced three significant measures:

– Opened a window for banks to swap fresh Foreign Currency Non-Resident (Bank) deposits which is expected to pull in at least $10 billion without affecting the interest spread by exempting them from cash reserve ratio and Statutory liquidity ratio.
– Raised the borrowing limit of banks from 50 per cent of unimpaired Tier 1 capital to 100 percent with 100 bps discount to the market swap rate. This will enhance the borrowing capacity of banks by an additional $30 billion.
–  Gave exporters and importers greater flexibility in risk management by easing forward exchange contracts.

The market response was quick and positive. The rupee and the stock market bounced back in a single day. That was the kind of push the markets required and with further measures, can be built upon to steady and strengthen the rupee.

Will the rupee harden much further? That is difficult to assess. There are too many unpredictables.  The manner and timing of quantitative easing, the duration and extent of possible military intervention in Syria, the pressure on the government’s budget from subsidies, food inflation and the general elections will all impinge on the markets for currency, commodities and stocks. In quieter conditions the rupee should crawl back to 60 against the dollar.

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