India’s concerted effort to shore up the battered rupee over the past two weeks has had one goal in mind: raising currency-adjusted yields to a level where even investors wary of a withdrawal of cheap money from the U.S. would still buy emerging market assets. The central bank has raised overnight money market rates by more than 300 basis points – a spate of tightening not seen since early 2008 – and sharply inverted the swap and the bond yield curve in less than two weeks.
From an offshore perspective, FX implied yields have jumped from a chunky 6 percent last month to well over 8 percent this week. But the risk-reward has not come cheap. For all the pain caused in the world of domestic interest rates, the Indian rupee has barely edged higher. Part of the reason is the Reserve Bank of India’s sledgehammer steps last week have been offset by other actions taken by the central bank and conflicting talk from government officials assuring lenders – the biggest players in the domestic bond markets – that these measures are temporary.
While New Delhi and Mumbai seem to be at last reading from the same page on communications policy this week, there seem to be two scenarios evolving. The first and more optimistic option is that bond investors give the thumbs up to the RBI’s steps and start shoveling money again into the markets after taking nearly $8 billion out of bonds since June.
Whether that is due to this money market crunch or a sovereign bond floated by the government is just a matter of which proves more politically feasible. The other, rather pessimistic scenario is that bullish equity investors faced with a weakening rupee, slowing growth and rising cost of capital for firms begin pulling their money out. That would add more pressure on a government already faced with plugging a current account of nearly $300 million a day.
In the short run, the RBI seems to have won the battle by stabilizing the currency below a record low over 60 per dollar and, given the extent of bearishness on the rupee, a short-term squeeze is on the cards. Over a longer horizon, the government needs to take tough measures to reform its markets, expanding on steps taken last week that opened up access to local industries, including the telecoms sector.