rediff.com: Weak rupee puts pressure on monetary policy

The Reserve Bank of India is likely to tighten liquidity to relieve the immediate pressure on the rupee and the upward trend in interest rates is likely to be maintained, analysts felt.

The RBI hiked interest rates and tightened liquidity on July 21 when the rupee weakened through 45 per dollar, but the respite for the currency was brief and it touched an all-time intra-day low of 45.38.

Rising commercial credit demand and a heavy government borrowing programme are pushing rates higher, while fears the US may raise rates again is also exerting pressure.

"Interest rates are going to rise from current levels...there's nearly 60 per cent of government borrowing yet to be completed, bank credit is up sharply, inflation may rise further if administered prices are revised upwards and the foreign exchange volatility may continue," M R Madhavan, analyst at ICICI Securities and Finance, said.

The government has raised 40 per cent of its Rs 1.17 trillion borrowing for 2000-01 (April-March), and inflation, based on wholesale prices, has crept up to 6 per cent.

Ten-year bond yields have risen 110 basis points since April and are expected to jump another 40 basis points by September, analysts said.

For now, the RBI's best option to contain the rupee's fall is to either spend reserves, which it appears reluctant to do, or keep liquidity on a slow drip through aggressive government bond auctions and through its daily auctions of securities repurchase agreements and reverse repos.

The RBI announced rises in banks' cash reserve ratio, in two stages, to 8.5 per cent from 8 per cent, and halved banks' refinance limits, and increased the bank rate - the rate at which commercial banks can refinance - to 8 per cent from 7 per cent.

Other administered rates like export and import finance were raised in June to even out trade flows.

The RBI hoped its liquidity squeeze would kill speculation against the currency, which is only convertible on the current account, and the interest rate rise would persuade exporters to remit their earnings faster.

The central bank had several reasons for raising rates, but the rupee's weakness proved the deciding factor.

It was hoped the move would restore India's interest rate premium, which had been eroded by rising US rates.

In the past year one-year dollar rates have risen from around 5 per cent to 7 per cent.

Add another three to four percent of swap premium gained by selling dollars forward and the returns are better than most local banks' deposit rates of 8-10 per cent for the same maturity.

"Their (the RBI's) entire attempt would be one of maintaining the interest rate differentials to avoid mass shifts in the means of financing," Morgan Guaranty Trust Company said in a market commentary.

Analysts feel the chances of large banks like the State Bank of India hiking lending rates now is very high.

Credit growth has been robust. Year-on-year growth so far has averaged 23-24 per cent against last year's 17 per cent.

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