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RBI's cruel dilemma

S. Balakrishnan

IT has become a familiar routine. A demand-supply imbalance in the forex market sends the rupee down. After watching the action for a few days, the Reserve Bank of India warns the market that speculation against the Indian currency will not be tolerated. At the same time, it squeezes liquidity in the money market, hoping that punitive domestic interest rates will stabilise the exchange rate.

We are going through exactly this now. What makes our situation different is that although there is no capital account convertibility for residents, the RBI is compelled to use the interest rate weapon to defend the currency. One would have thought that controls on the outward flow of domestic capital confer greater interest rate freedom on the central bank.

Evidently, the RBI's fears centre on the inter-bank market. If money market rates are soft, it is enormously profitable to borrow the weakening rupee and create short-term dollar assets. There is scope for arbitrage in the spot and forward markets in whi ch the domestic currency is always at a forward discount.

It is possibly this loophole which the RBI wants to plug by forcing up rates in the money market. Call rates have crossed 10 per cent and eliminated the risk-free plays in the forex market. Indeed, if short-term rates are 12 per cent or more, it might ma ke sense to borrow dollars for deployment in rupee assets, which might boost the currency.

How long can high money rates be sustained in defence of the rupee? The effects of tight liquidity are filtering through to the bond market. One of the main reasons for buoyancy in gilt prices was the wide spread between their yields and overnight rates.

Easy money at the short-end was converted into easy profits at the long-end. The appetite for gilts will shrink considerably if this reverses and there is no positive carry. The monetary authorities are stuck: they must facilitate profits from bond inven tories to avoid devolvement of the Government's borrowing but this could damage the rupee.

The RBI must be more relaxed about the exchange rate. It is probably worried about importing inflation through currency depreciation but these fears are highly exaggerated. In modern economies, productivity and competition influence prices much more than traditional factors.

Meanwhile, gyrations in money market rates do not seem to be doing anybody any good and only underline the irrelevance of the Bank Rate. The marginal (repo) rate is so far removed from the Bank Rate that the latter has lost all significance for day-to-da y liquidity planning.

The consequences of complete fiscal indiscipline are coming home to roost. The size of the Government's financing requirements commits the RBI to an expansionary monetary policy lest interest rates rise too high. No wonder the central bank displays its i ron fist in the money market and velvet gloves in gilt auctions. But for how long can the forces of supply and demand in the forex market be kept at bay? The central bank will soon have to choose between the exchange rate and interest rate.