The Reserve Bank of India (RBI) will carry out an open market operation and sell government of India bonds worth Rs 12,000 crore today, i.e. July 18, 2013. The RBI carries out an open market operation in order to suck out or put in rupees into the financial system. When the RBI needs to suck out rupees from the system it sells government of India bonds, like it is doing today.
Banks and other financial institutions buy these bonds and pay the RBI in rupees, and thus the RBI sucks out rupees from the market.
The rupee has had a tough time against the US dollar lately and had recently touched an all time low of 61.23 to a dollar. By selling bonds, the RBI wants to suck out rupees from the financial system and thus try and ensure that rupee gains value against the dollar.
The RBI has been trying to defend the value of the rupee against the dollar by selling dollars from the foreign exchange reserves that it has. When the RBI sells dollars it leads to a surfeit of dollars in the market and as a result the dollar loses value against the rupee or at least the rupee does not fall as fast as it otherwise would have.
The trouble is that the RBI does not have an unlimited supply of dollars. Unlike the Federal Reserve of the United States, the RBI cannot create dollars out of thin air by printing them. In the period of three weeks ending July 5, 2013, as the RBI sold dollars to defend the rupee, the foreign exchange reserves fell by $10.5 billion to $280.17 billion.
At this level India has foreign exchange reserves that are enough to cover around 6.3 months worth of imports. Such low levels of foreign exchange expressed as import cover hasn’t been seen since the early 1990s. Given this, there isn’t much scope for the RBI to sell dollars and hope to control the value of the rupee. It simply doesn’t have enough dollars going around.
Hence, it is trying to control the other end of the equation. It cannot ensure that there are enough dollars going around in the market, so it is trying to create a shortage of rupees, by selling government of India bonds.
In fact, as part of this plan the RBI has also put an overall limit of Rs 75,000 crore, on the amount of money banks can borrow from it, at the repo rate of 7.25 percent. Repo rate is the interest rate at which RBI lends money to banks in the short term.
Banks can borrow money beyond this limit at what is known as the marginal standing facility rate. This rate has been raised by 200 basis points (one basis point is one hundredth of a percentage) to 10.25%. Hence, borrowing from the RBI has been made more expensive.
A major motive behind this move was to rein in the speculators. As Jehangir Aziz of JP Morgan Chase wrote in The Indian Express, “It has been ridiculously cheap over the last month to borrow rupees at the overnight rate, buy dollars and then wait for the exchange rate to crumble. In June, the monthly overnight interest rate was 0.5 per cent and the depreciation 10 per cent.”
We can understand this through an example. Let’s say a speculator borrows Rs 54,000 at a monthly interest rate of 0.5%. This is at a point of time when $1 is worth Rs 54. He uses this money to buy dollars and ends up buying $1,000 (Rs 54,000/54). When he sells rupees to buy dollars, it puts pressure on the value of the rupee against the dollar.
After buying dollars, the speculator just sits on it for a month, by the time rupee has depreciated 10 percent against the dollar and one dollar is worth Rs 59.4 (Rs 54 + 10 percent of Rs 54). He sells the dollars, and gets Rs 59,400 ($1000 x 60) in return. He needs to repay Rs 54,000 plus a 0.5 percent interest on it. The rest is profit. This is how speculators had been making money for sometime and thus putting pressure on the rupee.
By making it more expensive to borrow, the RBI hopes to control the speculation and thus ensure that there is lesser pressure on the rupee.
The message that the market seems to have taken from the efforts of the RBI to create a scarcity of rupees is that interest rates are on their way up. The hope is that at higher interest rates foreign investors will bring in more dollars and convert them into rupees and buy Indian bonds. Foreign investors have sold off bonds worth $8.4 billion since their peak so far this year.
When foreign investors sell bonds they get paid in rupees. They sell these rupees and buy dollars to repatriate the money. This puts pressure on the rupee and it loses value against the dollar. The assumption is that at a higher rate of interest the foreign investors might want to invest in Indian bonds and bring in more dollars to do so. This strategy of defending a currency is referred to as the classic interest rate defence and has been practised by both Brazil as well Indonesia in the recent past.
But there are other problems with this approach. Rising interest rates are not good news for economic growth as people are less likely to borrow and spend, when they have to pay higher EMIs. A spate of foreign brokerages has cut their GDP growth forecasts for India for this financial year (i.e. the period between April 1, 2013 and March 31, 2014). Also sectors like banking, auto and real estate are looking even more unattractive in the background of interest rates going up. In fact, auto and banking sectors were anyway down in the dumps.
Slower economic growth could lead to foreign investors selling out of the stock market. When foreign investors sell stocks they get paid in rupees. In order to repatriate this money the foreign investors sell these rupees and buy dollars. And if this situation were to arise, it could put further pressure on the rupee.
Hence by doing what it has done, the RBI has put itself in a Catch 22 situation. But then did it really have any other option? The other big question is whether the politicians who actually run the Congress-led UPA government will be ready to accept slow economic growth (not that the economy is currently on steroids) so close to the next Lok Sabha elections? On that your guess is as good as mine.
