All eyes are on Raghuram Rajan, the new Reserve Bank governor, as he prepares for his first monetary policy statement this Friday. While it is difficult to predict what he will do, the market would like him to reverse July's liquidity tightening measures because it isn't helping in taming the unwieldy current account deficit, driven by gold, oil and coal imports. Demand for these commodities cannot be curbed through interest rates.
Though a lot depends on the much-feared US Federal Reserve's move, expected on Wednesday, to taper its bond buying programme, the markets would like some clarity on which way interest rates are headed.
It is becoming clear the rupee's 28 per cent fall between April 30 and August 28 was largely caused by a crisis of confidence, triggered by foreigners' selling in the bond markets. Additionally, about $13 billion made its way out of the country between July and August on account of hedging by corporates, leading to further volatility in the rupee. Anand Shanbhag of Avendus Securities believes high interest rates or prices don't affect the demand for coal, gold or crude oil. But, the sources of funding in the capital account (portfolio flows, foreign direct investment and foreign loans) are affected by high interest rates. Going by these factors, there are chances of RBI revoking its tightening measures when the time is appropriate.
Much of what happened in August had to do with panic. Credit Suisse estimates between July and August, about $13 billion exited through panicking corporates hedging themselves. If the theory of panic is to be believed, the rupee's depreciation can reverse even faster, rendering the liquidity tightening of July redundant. So, be it from the point of view of a bloated current account deficit, thanks to imports, or the rupee's depreciation due to panicky outflows, there is little merit in continuing with the liquidity tightening measures.
A section of experts believe the panic around the currency's volatility has been overdone. Once RBI's measures to offer swap lines to oil marketing companies and forex swaps for banks start yielding dollars by mid-November, the central bank might be able to recoup its foreign currency reserves, too, easing the pressure on balance of payments. For the time being, RBI may continue with its tightening measures, till December. However, if the Federal Reserve defers the tapering of its bond buying programme, things could take a different course.