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The RBI has added to the chaos in the currency market by leaving policy rates and the cash reserve ratio unchanged in its monetary policy. The announcement comes a week after the RBI tightened liquidity in the domestic market, pushing up interest rates to defend the rupee. Policy rates were left unchanged to indicate to the market that the RBI is not raising rates to control inflation. Instead, the message delivered was that the hike to tighten liquidity was temporary, and that it would be reversed. All this has added to the policy confusion and uncertainty. If the RBI had withdrawn the measures because they hurt growth, the market might have stabilised. The recent decisions have impacted long-term yields as seen in the government bond auction, the inflation indexed bond sale attempt and the sentiment in the economy. No one knows when the RBI will withdraw the measures. No one knows what the RBI will do after the next monetary policy meeting of the US Fed.
By indicating that the measures it took are temporary, the RBI has hinted that once this support is withdrawn, interest rates will go down again. This was done in a scenario where the rupee depreciation was sparked off by an increase in the interest differential with the US due to the Fed indicating that it will taper off QE and US rates will rise. It indicated, therefore, that the differential that has been narrowed by the recent moves will go up again. This suggests that the rupee will weaken further. Expectations of a depreciation will make capital fly out of the country rather than pull it in. It also indicates that the RBI will focus on defending the rupee when it deems it necessary and that will increase volatility in the Indian stock market.
The RBI-government strategy appears to signal that in a week or two, major reform measures will be announced. These measures are expected to pull in capital and restore hopes of rupee appreciation. In this environment, people will believe that the rupee overshot, that it will now become stronger and thus bring capital in to earn those returns. There is a risk that the reforms the government announces may not be able to pull capital in unless they are very radical. Maybe this is the time to privatise public sector banks and enterprises, initiate labour reforms and rethink legislation like the Food Security Bill.