RBI’s Failure to protect Rupee Calls for a Bazooka

Three days after the Reserve Bank of India (RBI) roiled the bond market with an interest rateincrease to prevent the rupee’s slide, the currency is just 0.4% higher than what it was beforethe shock. If the exchange rate is the gauge, what governor Duvvuri Subbarao fired was a squirtgun, and not a bazooka.

But the collateral damage to the bond markets has been immense, with many a portfoliobleeding, and probably undoing years of efforts to build investor interest in bonds that wasbeginning to show results with inflows into mutual fund schemes.With a half-hearted text bookinterest rate increase to stem the currency fall yielding little, the expectation now is thatpolicymakers will have to demonstrate that US dollars are flowing in — either through asovereign bond issue, or one to non-resident Indians. The so-called measures to boost foreigndirect investments (FDIs) are a long way off, even if investors respond to them. RBI’s actions inthe past three days — be it rejecting bids at the treasury bill and bond auctions, and reducingliquidity and opening the window of liquidity for mutual funds — have confused rather thancalming investors. Higher interest rates cannot draw foreign funds, given that US treasuries at2.5% are more attractive than Indian government bonds at 8%, if currency hedging costs arefactored in.

Nothing less than showing the US dollars through a bond issue, and strong measures to curbimports with either higher duties or tightening credit to imports like the government did for gold,could prevent a rupee slide. Indeed, the spike in interest rates militates against Subbarao’stheory of ‘Indian exceptionalism’ which essentially is that unlike text book cases, foreign flowsfrom equity funds into India rise when interest rates fall because it would boost economic growthand corporate earnings.

“The recent RBI moves do not ensure an effective curbing in pressures on the rupee since theycan potentially lead to FII outflows, especially in the current backdrop of a prolonged phase ofweak growth,” say Rahul Bajoria and Siddhartha Sanyal at Barclays. “Therefore, the recent RBImeasures are not enough to stabilise the rupee.”

On Monday, RBI raised the cost of borrowing under the marginal standing facility by 200 basispoints and narrowed the window of borrowing for banks from it to just one percent of deposits atRs. 75,000 crore, citing the need to “restore stability to the foreign exchange market”. A basispoint is 0.01 percentage point.

“Demand for foreign currency has increased vis-à-vis that of the rupee in part, because of theimproving domestic liquidity situation,” it said referring to traders borrowing rupee to buy USdollars expecting a fall in the value of the Indian currency. Hence, the need to reduce the float.In response, the rupee rose to a high of Rs. 59.19 to the US dollar on Tuesday. It remains belowthe 59-mark and ended at Rs. 59.67 on Thursday.

But the damage to the bond markets is severe, with traders saying that mark-to-market andactual losses are running into thousands of crores. A back of the envelope calculations showsmutual funds alone lost Rs. 6,000 crore. Banks and insurance companies are bigger. Unlikeequity markets where market capitalisation erosion could be used to capture losses, there isnone for bond markets. Yields on 10-year government treasuries rose to a high of 8.13% onTuesday from 7.5% on Monday. Commercial paper rates jumped to 10.45 % and have easedsince to 10%. Bond prices and yields move in opposite direction.

If the target is to make borrowing expensive for speculators, the RBI’s actions have achieved it.But the irony was when traders bid at higher yields on its treasury bills auction, it rejected themon Wednesday. Again on Thursday, it sold about a fifth of the Rs. 12,000-crore bonds it wantedto sell to suck out liquidity, because the yields quoted were higher.

“You raised the borrowing costs, but you do not want to accept bids at higher yields… what isthat you want,” asks a frustrated trader who did not want to be identified. “The entire exerciseseems to have been done without realising the possible impact on the bond markets.”Some traders argue that there was little data, or evidence, to show that it was the rupee liquiditythat was used by speculators. With the RBI calling dealing rooms every hour and keeping ahawk’s eye on net positions, there is little that banks could speculate on. It will be at their ownperil, and few could afford that.

The biggest beneficiaries in this botched attempt to stabilise the rupee are the institutionstrading in interest-rate swaps, the derivative to bet on interest rate movements. Five-year swapswere around 7.5% or so last week and they rose to 8.13% after RBI’s measures.

Old timers recall January 1998, when former governor Bimal Jalan launched a more powerfulattack with increases in repo rate, the rate at which the RBI lends to banks, and cash reserveratio, the portion of deposits to be kept aside, after the Asian crisis threatened to destabilise thesystem. But 2013 is different. The current account deficit is more than double of what it wasthen. Foreign portfolio investors were insignificant then, now they have nearly $280 billion indebt and equity put together. Any global event such as Fed tapering bond purchases couldinfluence flows affecting the currency.

“Monetary tightening cannot, but have limited impact at this point as the differential with the USFed is already a sizable 700 basis points vis-à-vis the 150 basis points when governor Jalanhiked rates to fight rupee volatility in January 1998,” says Indranil Sengupta of Bank of AmericaMerrill Lynch.

Jalan followed up his ‘shock and awe’ policy with Resurgent India Bonds. Will Subbarao deliversomething similar?

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