Much can be said about the adverse effects of a depreciating currency on an import-dependent economy like India. It widens our fiscal deficit; risks fuelling inflation, and generally troubles a slowing economy.
At such a time, the RBI’s actions are imperative. Here’s a look at how RBI defends the Indian currency:
Decrease speculation Currency trading is when one country’s currency is expressed in terms of another. It is highly volatile and speculative. Any negative news can affect the valuation of a currency to fall. This is the basic rule of forex trading. The RBI is trying to attack the depreciation at its root – reduce speculation by making it difficult.
Limit borrowing If there is a shortage of liquidity in the market, banks borrow from the RBI to fund this deficit. The RBI has made borrowing costly by capping borrowing of funds by banks as part of repurchase agreements to Rs 75,000 crore. This is called the Liquidity Adjustment Facility or LAF. With banks having to look at market borrowings for funds, the yields drop, attracting more buyers, including foreign institutions.
Increase interest rates Any additional borrowing over the LAF limit is at a higher interest rate called the Marginal Standing Facility (MSF) rate. This too has been increased by 2% to 10.25%. The RBI has also hiked the bank rate – the discounted rate at which the RBI lends to banks – by 2%.
Park more funds Currently, banks have to maintain 4% of its deposits as cash reserves, reported every fortnight. So on a daily basis, cash reserves can fall as low as 2.8%. The RBI has removed this flexibility and mandated that banks maintain minimum 3.96% of deposits as reserves every day.
How equity markets are affected Considering the prospect for the rupee, RBI is likely to hold or hike interest rates. This is expected to hurt corporate plans for any expansion. Besides increasing the borrowing cost for businesses, it also affects revenue and profit growth. Equity markets are unlikely to witness significant gains in such a situation.
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