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To hike or not to hike: The RBI dilemma
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$23 billion
This is the amount that the RBI has depleted in foreign reserves as a measure to control the volatility in the Indian currency, according to a report by the Economic Times. India’s foreign exchange reserves are down to $403 billion in August from a peak of $426 billion in April. The central bank’s goal is not to target the foreign exchange rate but to contain rising prices in the country.
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Publish date: 17th August, 2018
The Reserve Bank of India (RBI) is doing all it can to maintain inflation at a steady rate in the economy. Following its rate hike measures during the third bi-monthly monetary policy meeting, the RBI faced yet another surprise in the form of the depreciating rupee.
Let’s discuss the different factors that create a huge dilemma for the RBI when it comes to rate cuts.
1) RBI’s measures to tackle inflation
In its monetary policy statement for August, the RBI increased the repo rate by 25 basis points (bps) to 6.50%. This is the first back-to-back hike in interest rate in nearly five years as the RBI tries to control inflation in the economy. This didn’t come as a big surprise as the RBI aims to maintain inflation at 4% in the medium term.
Click here to read all about RBI’s decision to hike policy rates
2) Unexpected rupee depreciation
In the RBI’s monetary policy report, increase in Minimum Support Price (MSP) and volatility in global crude oil prices were among the key risks that could prevent the RBI from achieving the 4% target. However, the RBI faced a fresh challenge in the form of rupee depreciation as a result of a plunge in the Turkish Lira and the Chinese Yuan.
For the first time in history, the rupee hit the 70-mark as a result of global contagion effect. This seems problematic because a weak rupee only complicates the RBI’s task of keeping prices in control.
Click here to read what to do about the Rupee at Rs 70/$
3) RBI’s inability to curb the rupee’s fall
The RBI has tried to stem the fall and stabilise the rupee by selling dollars through state run banks. However, the RBI’s intervention may not help because the rupee’s current depreciation is a result of global factors according to Subhash Chandra Garg, the Economic Affairs Secretary.
Currencies of other emerging markets are also falling and as of now, the government is yet to assess how long the volatility in the rupee will last. Many experts were of the opinion that the August rate hike was the last one for the year. But with this new challenge in the form of rupee depreciation, another rate hike in the following months cannot be ruled out.
Click here to read how the RBI defends a falling rupee
4) How depreciating rupee is bad for the economy
A depreciating rupee affects the economy negatively in many ways. High cost of crude oil imports is one of the biggest concerns. India imports around 86% of its crude oil from other countries. The fall in rupee’s value means that we have to pay a lot more per barrel of crude oil. This creates a big spike in the crude oil bill which in turn affects India’s trade deficit and fuels inflation.
Click here to read how rise in crude oil prices affect the economy
5) Interest rate hike bad for corporate growth
The corporate sector also fares badly when the rupee depreciates. When the rupee’s value falls against the dollar, companies see a rise in input costs because they have to pay higher amounts to import goods and equipment. If the rupee depreciation continues, the RBI may be forced to keep policy rates at a higher level. This adds a great deal of pressure on corporate margins.
Click here to read the connection between rupee value and exports
