RBI's battle with currency weakness inverts the yield curve; will cost India's economy dearly

by SoberLook

The Reserve Bank of India decided it has had enough of rupee weakness and capital flight out of the country. The central bank is dealing with the problem by tightening liquidity conditions in the domestic money markets. By making it more expensive to borrow rupees, it reduces investors' ability to short the currency.

Reuters: - The central bank tightened liquidity further and made it even harder for lenders to access funds with measures including lowering the amount banks can borrow or lend under its daily liquidity window.
The latest moves come a week after its initial steps steadied the rupee somewhat, but left the currency still within sight of a record low of 61.21 hit on July 8.

The RBI's move has some similarities to what had recently occurred in China, as the PBoC tightened liquidity conditions there (see post). As a result of these actions, interest rates spiked - particularly on the short end. The chart below shows the dramatic jump in 1-year government bond yield.

Source: Investing.com

The central bank is also intervening directly in the currency markets.

Reuters: - The RBI is intervening more frequently in spot markets, traders said, coming in late in the session or whenever the rupee threatens to break below 59.89, the level at which the currency traded before the RBI's initial measures on July 15.
The central bank's steps, though meant to be temporary, are a clear indication of its renewed focus on financial stability, putting a monetary easing campaign intended to revive growth on hold.

Moreover, many domestic investors, concerned about the currency declines and uneasy about the economy, have been taking the only logical step one takes when currency flows are restricted. They have been buying gold. But domestic purchases of gold generate gold imports into the country, which puts further downward pressure on the rupee. This was another situation of whac-a-mole and the RBI brought down the hammer.

The Economic Times: - The Reserve Bank of India has made gold imports for domestic consumption tougher and forced exporters to bring home their dollar earnings quicker in yet another attempt to shore up the currency that's hurtling toward the Rs 60 mark to the US dollar again.
If any importer of gold fails to export 20% of the gold from the arrived consignment, he would be barred from importing any more gold. This could reduce imports, as only a very small portion of gold is exported now. The central bank's move is also aimed at promoting export of gold and to prevent charges that its measures to improve the fortunes of the rupee are hurting jobs in the gems and jewellery industry that employs more than 3 million people.

See this story for the full list of measures taken by the RBI to defend the currency. So far the impact on the rupee has not been significant as the currency continues to trade near the lows. Further declines have been halted for now however.

USD/INR

But this battle to keep the rupee under control is going to come at a price. The combination of this spike in rates and tight liquidity conditions will damage domestic credit and dramatically slow growth. This comes at a time when industrial production is already down in June, balance of trade is deep in negative territory, currency is weak, and fuel prices are elevated (see post).
As usual, the best predictor of an impending economic slowdown is an inverted yield curve - and that's precisely the situation in India now.

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