Why RBI’s surprising decision to not hike rates makes sense

Publish Date: October 09, 2018

The Reserve Bank of India’s decision last week to not hike the lending rates has divided opinion.

While some have criticized the central bank for being passive, economists on the other side of the fence believe it to be a well thought-out decision.

Why was there a demand for a hike in lending rates?

The answer: to prop up the falling rupee.

The rupee has been trading at near-lows against the US dollar in the last two months or so. It has shed 14% of its value since the beginning of the year.

Monday (October 8) marked the first time the rupee ended the day below the 74-mark against the greenback.

Effects of the rupee rout

India’s oil import bill is likely to balloon due to soaring global crude prices. It will get even worse because a weakening rupee will inflate the import bill even further. Some media reports suggest that India would have to pay an extra $26 billion to meet its oil requirements now.

Related read: Fuel prices are on fire

Secondly, foreign investors are pulling out their investments from India. The strong capital outflow is another reason for the rupee to go soft. In fact, overseas investors have pulled out more than $3 billion from the debt markets alone this year.

But, critics argue, if the RBI had hiked rates in the October 4 meeting, India’s domestic debt would remain attractive for foreign investors.

Thirdly, the US economy is doing well — it grew 4.1% in the second quarter. As a result, the dollar has gained strength, making it more attractive than rupee now.

Fourthly, India’s current account deficit is expected to widen this year. Last year, the deficit was 1.9%, but Nomura Research believes that it would stretch to 2.8% this year. The expanding CAD would put further pressure on the rupee.

Related read: What a high current account deficit means to investors

These are some of the reasons why some economists expected the RBI to hike rates. They felt that hiking lending rates could make the debt market attractive for foreign investors. Therefore, it would increase the demand for and the value of the Indian rupee.

The other side of the argument

We, at Kotak Securities, believe that a rate hike of 25 basis points would be a temporary solution. The rupee would gain strength for a brief while before capitulating to the triple trouble of high oil prices, trade wars and widening current account deficit again.

In fact, we are of the opinion that there is some more weakness left in the rupee before things get better.

We also think that the state elections in five states — Chhattisgarh, Madhya Pradesh, Rajasthan, Telangana and Mizoram — in November and December would fuel further uncertainties in the economy. The confusion in the economy would indirectly hurt the rupee too. Therefore, the rate hike would only be a short-term fix.

If you remember, the rupee had weakened in 2013 as well. That time, India’s central bank had raised the lending rates, but it proved futile in the long run. Foreign investors weren’t lured either. Basically, the rupee had to run the downhill course before it rebounded. The lesson here is that no artificial prop-up would help revive the rupee.

To sum up, oil prices need to climb down and global uncertainties need to dissipate for the rupee to gather its strength.

For the moment, the RBI is doing the right thing by adopting a wait-and-watch policy.

We feel the RBI will only jump in under two scenarios: first, if the rupee situation worsens further and two, if the weakness in the rupee riles the inflation numbers. But fortunately, inflation is unlikely to shoot up in the next two-three quarters, according to RBI estimates.

Lastly, a falling rupee has spurred higher trading volumes — its up by almost 60%. High trading volumes suggests there is a strong buyer interest.

The interest is high because people expect the rupee to fall even further. This gives them a chance to make a quick profit by selling the currency in the next few days or weeks. You can click here to use this opportunity as well.

To learn more about trading in currency derivatives, click here.

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