India’s RBI: tightening or loosening?

The Reserve Bank of India, the country’s central bank, has been busy this month with all kinds of efforts to tighten liquidity and make currency speculation more expensive.

But the big ticket announcement comes on Tuesday when it sets its repo rate – the rate at which banks borrow from the RBI – and its cash reserve ratio – the proportion of deposits that banks must have in hand as cash.

The repo rate was cut three times between January and April, as policy makers tried to boost India’s waning economy.

But since Ben Bernanke started making noises about rolling back quantitative easing, emerging market currencies have taken a battering. That has sparked several EM central banks into action. Brazil hiked its policy rate by 50 basis points to 8.5 per cent and promised tightening would continue. And in Indonesia too, the policy rate was hiked this month.

In India, the RBI has taken unexpected measures to tighten liquidity, upping rates on banks’ short-term borrowing and selling government securities in an attempt to suck up cash. Given the loosening path the central bank was following at the start of this calendar year, these measures are being seen as a temporary blip – analysts at ICICI Securities term them “confounding”.

Further rate cuts look near impossible given the increase in borrowing costs for commercial banks. So analysts expect the RBI to hold off making any changes tomorrow.

In the run up to the meeting, late on Monday, the bank published its macroeconomic review, cutting its inflation forecast for the current fiscal year to 5.3 per cent from the 6.5 per cent prediction it made in May. Overall, the analysis is gloomy, with comments about a slow recovery, a nod to falling business confidence and acknowledgment of the turbulent global financial markets.

“Whatever steps they wanted to take to tighten liquidity and push up short-term rates they have achieved with different measures,” said A Prasanna, an economist at ICICI Securities. “So the repo rate is meaningless. They could raise it just to signal that these measures are there to stay for more time. But conventional wisdom is that they have done this just to curb speculative action and not to slow down growth further to curb the current account deficit.”

A couple of dissenters say the repo rate could be raised tomorrow. But if that happens – and if that really is a signal that tightening is here to stay – it could be very bad news. In a note to clients, analysts at Espirito Santo Securities commented on the recent liquidity tightening:

If this is a short-term measure, then we do not expect a significant change to our views; however if this is the beginning of a shift from an accommodative monetary policy, then we see the entire financial system under pressure and expect earnings downgrades for most of the financial stocks, more so for stocks exposed to wholesale funding and wholesale assets.

If history does repeat itself you’d be safe in thinking the tightening was temporary. Analysts are making a parallel with the RBI’s recent actions and steps taken following the South East Asian currency crisis in the mid-90s. Then too, India’s policy makers were beginning to ease policy when external factors forced them into an about turn. In January 1998, rates were hiked abruptly but the easing began again in March when the rupee had stabilised, despite the fact that trade deficits were still rising and capital flows were negative.

In Monday’s statement, the RBI says the recent tightening provides “breathing time” – the suggestion is that these moves are temporary and that there is more to come.

The big difference between the mid-90s and now is the dependence of Indian markets on foreign institutional investment, particularly in equities. Back in 1998 such flows were near negligible but they are now around $200bn in BE500 companies alone. And any big adjustments in India’s economy today could trigger a sell-off, especially when growth has hit a lull.

That’s why analysts say more actions are needed to encourage foreign currency inflows – and they’re plugging for foreign currency denominated offshore bonds.

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