Huge risk to growth as bond yields at 14-month high
With the rupee always threatening to go out of control—it has depreciated 11.5% since the beginning of the year—RBI has gone and tightened liquidity further, in keeping with what other emerging markets like Brazil, Indonesia and Turkey have done in recent months. Whether that will work is not clear—the results have been mixed in the countries which have hiked rates—but it is consistent with what RBI wanted to do, to make it unprofitable for those trying to speculate on the rupee. Last week, by contrast, while RBI said it was trying to suck out liquidity, it actually ended up relaxing liquidity by giving banks the chance to mop up R2.1 lakh crore at the lower repo rate and by offering mutual funds special repo windows and by refusing to sell government bonds at higher yields. The problem with the strategy is that it is a very high risk one, with the downside looking dangerous. If the move does indeed convince market-participants—exporters who are delaying bringing back dollars and importers who are trying to hedge the bets before things get worse—that RBI is serious in defending the rupee, and it stabilises at current levels or even lower, it will have worked. Once the rupee stabilises, given the high differential between US and Indian rates—around 10-11% now—you could have FII inflows in the debt market once again. On Tuesday, after 10 trading sessions, where the FIIs withdrew $894 million from the debt market, they brought back $8.9 million; in the case of equity markets, they brought in $37 million on Tuesday—all told, FIIs withdrew $2.5 billion from July 1 to 15 when RBI first tightened liquidity and this reduced to $373 million between July 16 and July 23. Even though yield differences are very high, investors will not want to bring in funds since this can get wiped out with a depreciation of the rupee—so the rupee stabilising is critical.
The risk, however, lies in the possibility that market participants may not get convinced in the absence of other concrete measures by the government to attract investors—keep in mind that while the FII equity portfolio is $250 billion, the FII debt portfolio is around $35 billion. FDI levels are not rising because, despite the government’s much-vaunted raising of FDI caps last week, no changes were made in sectors like pharmaceuticals and retail where investors are still interested in coming in—in the case of gas, investors like BP have made it clear they will not invest unless prices are completely freed up. While the rupee stabilising remains a matter of speculation, bond yields rising to a 14-month high after Wednesday’s RBI measures has put economic growth at risk. Mark-to-market losses of the R16 lakh crore bond portfolios of banks will lower lending and also make it that much more difficult for corporate India to raise funds for any expansions being planned. In the short run, this may not matter, and it can be no one’s case that a 2-3 week liquidity squeeze will seriously dent the economy; but it will be a brave person who still believes the interest rate cycle has not turned, that RBI will still make a few more rate cuts in the months ahead. More important, with the Fed clarifying that it will not ease up on bond purchases immediately, the global pressure on the rupee has eased for now—but were US recovery to pick up pace, and the Fed to lower bond purchases, the pressure on the rupee would once again increase. In which case, it looks unlikely that RBI will call it a victory in a few weeks and restore liquidity. Many brokerages have already lowered estimates on India’s growth and more could follow. It’s not immediately clear whether the current account deficit, the original reason for the rupee’s weakness, will look better when growth slows.