A costly defence

RBI's interventions to curb the rupee slide could end up constricting investment and growth

The RBI stepped up its defence of the rupee by sharply tightening liquidity and pushing up interest rates. The measures might be effective in preventing further rupee depreciation, but they could also hurt hopes of reviving investment and growth. One of the significant steps taken by the RBI has been to restrict the amount banks can borrow from it to 20 per cent lower than the current level. It will conduct open market operations, selling bonds to further reduce liquidity in the market. Call rates have responded by going up, above the corridor of the repo and reverse repo.

The biggest question confronting the banking sector is whether this will merely flush out what the RBI believes is speculative capital affecting the rupee or hurt domestic bank lending, already suffering from the impact of declining investment and growth. Will it mean an increase in the lending rates of banks at a time when the economy can ill afford it? And if it does, what was the need to do it? While companies that recklessly undertook unhedged foreign currency exposure will benefit from actions preventing further depreciation, firms that were sensible and did not borrow in dollars will now have to face higher costs. The already slipping growth in employment will take longer to revive.

If interest rates had been raised in an open and transparent manner, after discussing the inflation and growth expectations of the economy and then raising the repo rate, the issue would merely have been one of disagreement with the stance of monetary policy. Today, the question is not merely one of monetary tightening, but also the manner in which it has been done. It comes with the pretence of not raising rates, but only tightening liquidity. Whether you raise the price of money directly or through changing the quantity, the net effect is the same, as seen in the call money market today. Further, the RBI has undermined the transmission mechanism of monetary policy that it has itself built in a fragile environment. First, by using instruments other than the repo rate, the RBI has undermined its own instrument. Second, it has attacked the 100 basis point corridor that it had carefully created, where the call rate remains between the repo and reverse repo rates. On the one hand, the finance minister is telling banks to cut lending rates, and on the other, the RBI is raising the costs of funds by tightening liquidity. Any effort to revive growth will undoubtedly suffer.

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