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The rupee defence strategy adds to the woes of a stressed banking sector.
The latest consequence of the battle to defend the rupee is going to be a weaker banking sector. The RBI's recent changes in regulation are intended to encourage banks to buy more long-term bonds. If banks expect interest rates to go up after the RBI's recent rate hike, they might avoid buying long-term bonds due to the fear of making losses. The RBI has now allowed banks to hold more bonds in the hold-to-maturity (HTM) book, where such losses need not impact bank capital.
This strategy appears to be part of "operation twist" — high interest rates in the short term and low rates at the long end. Normally, raising short-term rates leads to a transmission of higher interest rates to the long term. This can be avoided if enough demand can be generated at the long end. This complicated strategy is an element of the attempt to signal that the RBI favours growth and is thus keeping long term rates low. This is essential for the currency defence strategy being followed. Else, with the tight money, a signal of an anti-growth policy stance, FII money was flying out, and the rupee was continuing to fall. In trying to defend the rupee on July 15, the RBI tightened liquidity in the system and raised the marginal standing facility rate. This pushed up long-term bond yields, while pushing down bond prices. Ideally, banks should have booked losses by the amount of decline in the total price of their bond holdings. However, the RBI has been allowing banks to not show losses on the part of their portfolio known as hold-to-maturity. The RBI has now allowed banks to shift some of their mark-to-market bonds to the HTM category. This was done because otherwise many banks would have made losses. Since January, banks have been holding a large portfolio of long-term bonds in the expectation that interest rates would fall and bond prices would go up. They expected to make profits.
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