Propping up the rupee

The Reserve Bank of India8217;s measures to support the rupee by raising the bank rate and cash reserve ratio CRR seem too harsh, even panicky. The next few days will reveal exactly what the markets think of Friday night8217;s surprise announcement. It was responding to developments8217; in domestic andinternational markets, including the foreign exchange market, the RBI said. It might have added that there is an element of correction here as well,correction of its own earlier, overly optimistic assessment of the overall resources position and interest-rate structure. The benchmark bank rate goes up to eight per cent with immediate effect making the experiment with seven per cent, which was announced in April and led to a cascade of other interest rate cuts, very short-lived indeed. Further moves to squeeze liquidity out of the system include a half per cent hike in the CRR and a 50-per cent reduction in the limits of all refinance facilities. On coming into effect in two stages at the end of July and in the middle of August, these two measures will suck Rs 10,000 crore out of the financial system.

This could not have come at a worse time. Industry emerging from a long recession is demanding more credit and 60 per cent of the government8217;s massive borrowing programme has still to be met. It will take a miracle after this to hold down interest rates. The impact on the economy is bound to be severe unless the RBI soon reverses its latest measures. Not surprisingly, the Finance Minister was constrained to say it will all be temporary. A spell of confusion is inevitable across several financial sectors as the markets try to work out just how temporary temporary8217; is going to be. It is a worrying scenario, to say the least, and especially because the RBI8217;s primary concern which is to shore up the weakening rupee may not be met. After all, twice in this financial year the RBI has felt it necessary to intervene to cushion the fall of the rupee, once with surcharges and penalties for importers and exporters and the second time with a verbal warning to speculators. Each time the positive impact was felt for afew weeks before the rupee came under pressure again.

No single factor, such as dollar demand from industry or from foreign institutional investors who have been net sellers in the stock market for two consecutive months, explains the rupee8217;s fall to an all-time low of Rs 45. Rather a combination of factors arising from the volatility of international currency and stock markets since March must be taken into account. Since that in turn is the outcome of adjustments to the technology-driven new economy8217; it is unlikely that volatility will disappear in a hurry. So how far can the RBI go on racheting up its counter-measures to defend the rupee? Further bank rate increases this year have been foreclosed by going a whole percentage point this time rather than making incremental moves. The next steps can only impact on foreign exchange reserves which at 36.7 billion are comfortable but will come under sustained pressure unless international oil prices come down, export growth accelerates and foreign direct investment jumps several fold. The RBI8217;s job has become alot tougher.