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Economy: RBI's confusing signals

Apr 17, 2007

To contain undue widespread inflation, India's central bank, the Reserve Bank of India (RBI) has to reduce money supply on one hand, while its monetary policy has to fulfill the objective of domestic growth with export competitiveness on the other. While trying to juggle its stance on all three fronts, the RBI has managed to bewilder all players in turns. All these months, the RBI bought dollars, creating a demand for them when none existed, so that the Rupee is kept competitive for the exporters (a valid concern given India's trade deficit of US$ 40 bn for the 11 months ending February 2007). This adding of US dollars to RBI's account has single-handedly raised money supply by Rs 3,827 bn, while its Market Stabilisation Scheme (MSS) and Cash Reserve Ratio (CRR) hikes have sucked out a much lower Rs 2,385 bn. Thus money supply actually grew thanks to RBI's intervention in the dollar markets while domestic growth is strangulated with higher interest charges.

Yesterday, 16 April 2007, the RBI probably figured out that the effects of holding the Rupee down are worse, so it did not buy any more dollars. Consequently the Rupee touched its 9-year high of Rs 41.9 per US dollar. Great news for the hordes of Indians traveling abroad to beat the scorching Indian summer without the comforts of a continuous electric supply! But bad news for companies whose primary job is to manufacture a commodity that is sold outside India.

No less than Infosys has acknowledged a drop of 110 basis points in its margin as a result of the Rupee's appreciation, and goes into the next financial year with over US$ 400 m of covered exposures. If the Rupee continues to climb, these hedges will be in the money, but unhedged exposures will take a hit. On the contrary, if the Rupee hits the peak and then turns around (depreciate), some of these hedges will end up out of the money. Clearly, even for a powerhouse like Infosys, currency risk is a wild card.

Right ends, wrong means
The RBI has rightly focused on inflation control as its primary concern, but to paralyse domestic growth by raising the lending rates by 3% in as many months is probably not the most sensible way of going about it.

In these columns, we had expressed our doubts about raising domestic interest rates and wanting to hold the currency down simultaneously. Obviously money is pouring in from countries that have interest rates less than one-third of that in India, given the situation where every man and his dog had full confidence in the RBI supporting the dollar, come what may (NRIs deposited US$ 2.9 bn in FY07 up from US$ 0.3 bn a year ago and companies doubled their access to funds from the overseas markets to US$ 42 bn in the first 9 months of FY07). It was this confidence that got shattered when the RBI refused to play yesterday in the markets.

The RBI for once seems to have got its priorities on the right track. To help exports (that account for approximately 20% of GDP) by keeping the exchange rate stable is too high a cost to pay for by the rest of the economy. Even then the RBI seemed to have backed a losing horse as the pace of growth in exports itself has slowed to a sedate 6% since December 2007, as compared to the robust 31% average growth shown in the earlier eight months.

Lead on, RBI
A few capital controls might solve the problems of plenty in the short run, but the RBI and the government have to nurture a thriving futures market to provide exchange risk hedging, as well as a vibrant domestic corporate debt market to fulfill the funding needs of domestic entrepreneurs. Only then can the exporters not make merry at the cost of vibrancy in the domestic Indian economy.


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