• The Indian rupee touched a 14-month low last week. Most analysts expect it to continue to depreciate in the near term.
• The condition in the international financial market is tightening with yields on 10-year US government bonds touching 3%. This is one of the reasons foreign investors sold Indian stocks and bonds worth about $2 billion in April.
• Higher crude prices are also affecting bond prices, which in any case were under pressure due to the higher expected supply of government bonds.
• Higher crude prices, weakness in rupee, and rising bond yields have complicated policy choices for the Reserve Bank of India (RBI).
=> Where does the RBI Stand?
• All these have led to weak investor interest and which consequently led to low bid on the bonds offered by central bank.
• Market intervention by the Central Bank might end up hurting its own policy objectives in other areas, such as currency management and containing inflation.
• If the RBI intervenes in the market heavily, it will infuse liquidity into the system, which can affect outcomes on the inflation front and put further pressure on the rupee.
• If the central bank defends the rupee by selling foreign exchange, it could end up draining liquidity from the system, which will put pressure on bond prices and make government borrowing more difficult.
• The latest minutes of the monetary policy committee (MPC) meeting suggest that the committee might raise rates sooner than expected. While higher policy rates—apart from anchoring inflationary expectations—could be handy in attracting foreign debt capital, it will increase the cost of money and make government borrowing more difficult.
=> What Can RBI do?
• It is extremely important that the central bank doesn’t act in haste. All policy options should be carefully examined and then acted upon
• TENURE RESTRICTIONS: ease tenure restrictions for foreign investors in both government and corporate bonds which will give greater flexibility, leading to higher capital inflow in the bond market.
• This will not only reduce pressure on yields but will also help support the rupee. But greater dependence on short-term foreign debt is inherently risky and can further complicate currency management in the short-to-medium term, as interest rates in the international market are expected to go up.
• CURRENCY MARKET: RBI Should stick to the stated policy of not targeting any level and should avoid throwing foreign currency from its reserves, or aggressively opening up foreign investment in debt.
• It should only intervene to avoid excessive volatility. The RBI did well by accumulating large reserves in recent years, which will give confidence to market participants and help avoid excessive volatility.
• MANAGING YEILD: The central bank should stay away from managing yields.
• The government should accept that higher borrowings will increase the cost of money in the market. This will also underline the importance of fiscal discipline and is in line with the long-term idea of reducing financial repression.
• The MPC would be well-advised to maintain a pause for now and wait for actual information on things, such as the increase in the minimum support price.
• The monsoon is expected to be normal this year which will help contain inflation and inflationary expectations. Also, a rate hike at this stage could disproportionately raise the cost of money and affect economic growth, which is otherwise expected to strengthen.
• Rising international crude prices are putting pressure on India’s macroeconomic indicators and have complicated policy choices for the RBI. However, policymakers—including the central bank—should avoid doing too many things at this stage.