By Anup Roy, Subhadip Sircar and Bhaskar Dutta
Just months ago, India’s central bank pulled out all the stops to draw in dollars to bolster its foreign-exchange reserves and defend the rupee. The stronger-than-expected deluge of cash is now adding to the case for a more hawkish monetary policy stance.
The record $133 billion inflow from the Indian diaspora left banks awash with cash and pushed overnight rates below the Reserve Bank’s 5.25 per cent policy rate, effectively making borrowing cheaper than policymakers intend. The liquidity surge came at a time when credit growth is accelerating, domestic demand is proving resilient, while inflation is picking up.
Keen to prevent the excess liquidity from adding to price pressures, the RBI has already drained more than ₹1 trillion ($10.4 billion) through bond sales and other measures. Market participants expect it to announce further action in the coming days. At the same time, calls for an interest-rate hike next week are growing as rising food costs and elevated oil prices add to inflation pressures.
The prospect of a more hawkish RBI, alongside rising global bond yields, has driven Indian yields sharply higher and unsettled investors.
“It is important for the RBI to hike rates next week, take an appropriately cautious or hawkish tone to signal to markets that more may be in the pipeline,” Sajjid Chinoy, chief India economist for JP Morgan Chase & Co., told Bloomberg Television’s Paul Allen on Thursday.
Economists at Nomura Holdings Inc., Deutsche Bank AG, and Australia and New Zealand Banking Group are among those predicting the RBI’s first hike since early 2023 next week, with some bringing forward calls that previously anticipated a move in December.
In September, surplus banking-system liquidity swelled to as much as ₹11 trillion ($115 billion) as commercial banks swapped dollars for rupees with the RBI. The move also pushed the RBI’s foreign-exchange reserves close to $800 billion, the world’s fourth largest.
Leaving that money unchecked could have a “credibility cost”, impede monetary-policy transmission and fuel mispricing of risk in asset markets, Citigroup Inc. economists including Samiran Chakraborty and Baqar Zaidi wrote in a note.
Citi expects the RBI to gradually steer overnight rates toward the repo rate, mainly through short-term FX swaps and other interventions that can temporarily drain liquidity. It sees up to ₹1 trillion of bond sales as an additional option, according to a research note on Sept. 25.
While such interventions have helped the RBI’s cash drain efforts, they have also driven up the cost to guard against future rupee weakness, reflecting the market fallout of its attempts to counter easy financial conditions. Deutsche Bank’s Kaushik Das said the RBI may raise the cash reserve ratio “as a last resort” if other measures fail to absorb enough liquidity.
Meanwhile, surging oil prices — Brent crude rose for a third month in September — is making matters worse. The rupee is now trading near the levels seen prior to the RBI’s Foreign Currency Non Resident deposit plan, or FCNR (B), despite a steady stream of dollar-selling interventions by the central bank. Down more than 6 per cent year-to-date, it remains one of the worst-performing Asian currencies.
On Thursday, the RBI sold more dollars to support the rupee which was little changed at 95.8987 per dollar.
The RBI’s measures have put pressure on the bond market too. Benchmark 10-year yields climbed nearly 20 basis points last month, hovering near a two-year high. On Thursday, they held at 7.18 per cent. The jump comes as the government prepares to borrow nearly ₹8 trillion through March.
The predicament echoes what economists call the “impossible trinity” — the constraints countries face in simultaneously managing capital flows and the currency while pursuing an independent monetary policy.
“The FCNR(B) experiment has brought the trilemma uncomfortably close to home,” said R. Gurumurthy, a former regional director at the Reserve Bank of India. “The question now is if the central bank can judiciously leverage the liquidity situation to ensure the smooth passage of the government’s borrowing program, especially when pressures are building up on the RBI to raise rates.”
