Will rate cut affect the rupee?

THE Reserve Bank of India (RBI), in its recent Credit Policy, cut the bank rate half a percentage point to 6.5 per cent. Some people are of the opinion that the rate cut will pull down the rupee's value.

What is the link between interest rates and the rupee? To answer this, consider an open economy, where people are free to invest in any country, including their home country.

Since people are always seeking to derive maximum returns from their investment, they will naturally invest in the country that offers them a higher return.

If, for instance, the interest rate in the UK is 7 per cent, whereas it is only 6 per cent in Germany, people in Germany will prefer to invest in the UK. This means the people in Germany will sell the euro and buy the British pound.

As more people sell the euro, it will fall in value against the British pound. This is based on the principle of demand and supply. As people demand more of the British pound, its value will rise against the euro, which is the same as the euro falling against the pound.

The question is: Will Indian investors likewise sell the rupee and invest their money abroad because of the rate cut by the RBI? That is unlikely because India is not an open economy.

This means you and I cannot invest abroad even if interest rates are higher elsewhere. So, people will not sell the rupee to buy any foreign currency to invest abroad. The rupee should not, hence, fall in value because of the rate cut.

Of course, this does not take into account the foreign institutional investors (FIIs), who have invested in the Indian debt instruments.

There is a possibility that these investors may want to sell their investments and take their money to another country. But their investment in Indian debt instruments is very minimal, and hence, may not affect the rupee's value.