Markets see MPC hiking rates by 50 bps

Going by the three-month overnight index swaps (OIS), the markets seem to be expecting the monetary policy committee (MPC) to raise the benchmark rate by at least 50 basis points in the coming months.

With the growing clamour for the Reserve Bank of India to intervene and arrest the rupee's decline, will the MPC tighten monetary policy? If it does, will it do so to curb inflation due to the rupee's depreciation and the spurt in oil prices or will it be interpreted as a defence of the rupee? And, if status quo is maintained, what would be the other options before the RBI?

Typically, an interest rate defence of currency is meant to protect the real interest rate differential between countries. It is done to make rupee denominated assets more attractive to maintain capital flows.

Some analysts said since US Federal Reserve is expected to raise rates next week, the MPC will have to follow suit to maintain the interest rate differential. But hiking rates is unlikely to have the desired effects when globally investors are pulling out of emerging markets, said Pronab Sen, former chief statistician of India. “In a global risk-off scenario, higher interest rates may not help attract capital flows,” he said.

Devendra Pant, chief economist at India Ratings and Research, said: “I don’t think using monetary policy to defend the currency will have much impact.”

Rather most economists Business Standard spoke to expect the MPC to raise rates in its October 4 policy, in response to the inflationary consequences of depreciation rather than in response to defending the rupee.

Retail inflation moderated to 3.69 per cent in August, down from 4.17 per cent in July, but economists expect inflation to pick up in the coming months. “We expect inflation to remain around current levels or marginally higher in the coming months, but rise thereafter. Our March 2019 target is 4.8 per cent,” Suvodeep Rakshit, economist at Kotak Institutional Equities said, adding, “We expect a 25 bps hike on account of rising crude oil prices and currency depreciation leading to risks of higher inflation.”

Madan Sabnavis, chief economist at CARE, said the rate hike will supposedly be for curbing inflation but will serve a dual purpose. Some analysts are advocating a direct intervention by the RBI in the currency markets. A report by Soumya Kanti Ghosh, group chief economic advisor, State Bank of India, calls for the RBI to intervene to the tune of $25 billion.

While the RBI releases data on currency interventions with a lag, estimates by Abhishek Gupta, economist at Bloomberg, show the central bank has sold only $0.27 billion in the week ended September 7. Gupta’s data show RBI’s interventions have been relatively muted in the past few months. This is in line with RBI’s own data which show its interventions dipped after May and June.

Some economists agree with the RBI’s strategy of not intervening in currency markets.

“Using reserves to intervene in the market might bring momentary relief, but it is unlikely to stem the rupee's slide in a sustained manner. Reserves are already below the psychological $400-billion mark. Given the rout we are seeing across emerging markets, it’s unlikely to have the desired impact,” said Radhika Pandey, economist at the National Institute of Public Finance and Policy.

Then there’s also the overseas non-deliverable forward market (NDF) to consider. Over time, this market has grown in size. Recent research pegs it to be almost the same size as the onshore currency derivatives market, which reduces the effectiveness of RBI’s currency interventions.

“The offshore NDF premium today was significantly higher than the onshore counterpart, and is likely to have played a role in pulling the rupee spot down. It is this NDF that appears to be linked to the broader EM FX complex. According to the BIS’ last triennial central bank survey (in 2016), NDF volumes were well in excess of those onshore — making this a clear case of the tail wagging the dog. Without actual capital flows, arbitrage forces rupee to track the global EM FX basket, through the NDF mechanism,” Saugata Bhattacharya, chief economist at Axis Bank, said.

Other options before the RBI, economists said, would be to introduce a window for oil companies at the RBI to meet their needs directly as well as to issue NRI bonds.