By Arjun Deshpremi
New Delhi, The rupee has now depreciated by 6.2% since June 2018 when the RBI started hiking rates. Even as the decline in rupee is in consonance with strengthening of US$, we believe the decline may continue further and there are enough reasons to substantiate such.
There has been a spate of recent RBI communications in recent times which have perhaps gone unnoticed by the market. For example, in August Monthly Bulletin and also vividly emphasised in RBI Annual Report there is a detailed discussion on the costs of continued RBI intervention in the foreign exchange market.
In principle, if the attendant liquidity injected by RBI through dollar purchases is sterilised through open market sale of government bonds, it will harden domestic yields and result in greater capital inflows thus offsetting the very purpose of sterilisation.
Studies show that in Indian context, such offset coefficient has increased significantly from being in the range of -0.31 and -0.33 in 1990’s to around -0.79 and -0.84 in 2000s. A value of -1 for the offset coefficient indicates central bank ineffectiveness in sterilising capital flows.
Secondly, sterilisation by the RBI comes with associated costs. These costs arise because the RBI in lieu of sterilising, substitutes higher yielding government securities with lower yielding foreign securities.
There are other costs of sterilisation as well, which is however difficult to estimate. For example, sterilised intervention raises interest payments and subsequently revenue expenditure, squeezing out capital expenditure in the process . We estimate such costs per annum could be
around Rs 10,000 crore.
What do all these mean for markets? Given the inefficacy of sterilised intervention, we believe RBI may be thus following a relatively hands off policy in forex market for now and hence the recent penchant for rupee to depreciate at a much faster rate. For example, it took only one trading day for the rupee to travel 100 paisa on 13 Aug, as against a historical average of 17 days beginning Apr’18 (27 days in 2015)!
Hence, we should be utterly careful about any rapid depreciation and must be equally mindful of the quotes coming out from policy making authorities regarding the desirability of rupee depreciation (for the record, 11.5% rupee depreciation in 2018 is far higher than even Indonesia!).
Continued volatile depreciation, we strongly believe that may result in orthodox monetary policy measure like rate hikes in future thus slowing down consumption significantly as in past as in 2014.
In this regard, State Bank of India has also urge the Government and RBI to quickly implement Standing Deposit Facility (SDF) without any further delay as it has no sterilisation cost. In the interregnum till SDF is implemented, the RBI must continue with durable liquidity injections through regular OMO purchases so as to offset the current spate of liquidity withdrawals.