RBI wants rupee sub 60, but higher rates needed: Experts

The Reserve Bank of India (RBI) said yesterday that banks can borrow from the RBI against their collateral of government securities but the amount of money each bank will get will be only 0.5 percent of their total deposits which is also called as net demand and time liabilities (NDTL). For the system as a whole, 0.5 percent of total deposits means Rs 37,000 crore.

RBI’s monetary policy announcement on July 30 is going to be a crucial one this time as the markets will get the much awaited clarity on how long these measures will last. Also Read: RBI in prisoner's dilemma in FX/rupee; NRI bonds way out?
“If they are trying to achieve medium term currency stability then these measures are going to last for a while but if it is just about a shock therapy to cleanse up the system, if they believe that there are speculative positions in the system which will get cleaned up through this measure then it could be a relatively temporary measure and in that sense lending and deposit rates might not go up substantially,” says Samiran Chakrabarty of Standard Chartered Bank.
He further adds unless a country has a relatively stable exchange rate it is very difficult to convince FIIs to buy into its sovereign bonds. He believes the RBI is giving some kind of a breathing space before finding a solution to the flow issue, by coming up with something like a non-resident Indian (NRI) bond or something.
Ray Farris of Credit Suisse concurs and says it is clear from the string of recent measures that the government does not want the currency to be trading meaningfully above 60. But the government has not been consistent in enforcing tighter liquidity conditions and persistently higher interest rates, he told CNBC-TV18.
But if the RBI wants a stronger currency then it will have to raise rates, offer the markets higher yields. If the RBI does not raise rates, then it is going to discover again that its problem is large Current Account Deficit (CAD), Farris says. 
Neeraj Gambhir of Nomura India says the current RBI measures are a follow-through to make sure that the overnight rates stick to 10.25 percent. Below is the verbatim transcript of Samiran Chakrabarty, Ray Farris and Neeraj Gambhir’s interview on CNBC-TV18 Q: Is it a given that you are going to see deposit and lending rates rise, will some banks only wait till July 30? Chakrabarty: July 30 is going to be a crucial date where we are hoping that we will get some kind of clarity on how long these measures are going to last. And that is going to be a function of what RBI is exactly trying to achieve through these measures. If they are trying to achieve medium term currency stability then these measures are going to last for a while but if it is just about a shock therapy to cleanse up the system, if they believe that there are speculative positions in the system which will get cleaned up through this measure then it could be a relatively temporary measure and in that sense lending and deposit rates might not go up substantially. So we will have to see on July 30 how RBI is defining the framework for this kind of policy intervention. Q: As an onlooker, do you now get the feeling that the Reserve Bank of India (RBI) is determined to defend the currency? Is that one message that has gone that the currency will be stable from hereon? Farris: It is clear from the string of recent measures that the government does not want the currency to be trading meaningfully above 60. As was mentioned just a moment or two ago, the key problem with that is that the government has not been altogether consistent in enforcing tighter liquidity conditions and persistently higher interest rates.
So I think as the other speaker said that what is going to be key here is that whether RBI keeps the interest rate structure higher for long enough to start generating inflows into Indian bonds and make clear that it is willing to live with a much higher interest rates structure to prevent the currency from weakening. If it does not do that, if it thinks that all it is doing is trying to clear up speculative positions, it is going to discover again that its problem is large Current Account Deficit (CAD) in a world where it is tougher to finance that deficit and that should not have worked. Q: The previous measures by the RBI did not have so much of an impact. This time around are you expecting to have a significant impact on the rupee and secondly given the resolve shown by the RBI in curtailing the rupee volatility would you change your estimate on the three month target on the rupee? Farris: We haven't made any changes as yet. I think the issue is simply that the RBI wants a stronger currency. If it wants to get that it is going to have to offer the market higher yields and the measures that it took overnight if it allows them to persist will go in that direction. The problem with the inconsistency in the past was when it went into the market and tried to buy bonds, the market said well we want your pay up for this, they said no we are not going to do that and that is not really liquidity tightening.
So what I would come back to is if the RBI enforces these measures, persistently takes the interest rates structure up minimum 40-50 bps that we have seen today, may be a bit more, keeps rates tighter then it will probably be successful in containing the currency. If it is a very temporary action it is probably not going to be successful. Q: There is a flows issue over here. Given the tapering as well as India's lower and lower growth estimates, there is a problem with fresh Foreign Institutional Investor (FII) inflows for sure. It has not yet ballooned into a large FII outflow from equities. Do you think that irrespective of the movement on rates the government and the RBI will have to come with some kind of a flow issue, for instance on Non-Resident Indian (NRI) bonds or something before long? Is that almost a given now? Chakrabarty: The way I am looking at these measures, they are giving you some kind of a breathing space to think about what to do. So all these measures like sovereign bonds, NRI bonds or curbing gold imports etc., these measures cannot be taken when the market is extremely volatile.
So probably what RBI is hoping is that these measures will give some stability to the rupee, because there is a chicken and egg problem here. Unless you have a relatively stable exchange rate it is very difficult to convince anybody to buy an Indian sovereign bond. From that perspective I think this is giving some breathing space to think about those structural solutions to the higher CAD and funding of the CAD issue, but this is going to take time.
_PAGEBREAK_ Q: Looking at it from the shoes of a Foreign Institutional Investor (FII) investor in equities and bonds the raising of rates will willy-nilly spillover into the cost of borrowing at least in the short-term. It is inevitable that growth is going to take a back seat and there are already estimates coming in from brokerages lowering India’s growth estimates from 5.5 to 5 percent. Do you think in the process of guarding the rupee from speculative volatility the growth sacrifices may entail some FII outflows or are FIIs not yet worried about that bit? Farris: It is important to understand the core problem here. The core problem is India has a large CAD that needs to be financed and although inflation has moderated on some measures it hasn’t fallen altogether too meaningfully. So although there is a lot of focus on the idea of speculative activity weakening the currency, the reality is simply there is a large CAD that is difficult to finance because inflation hasn’t come down a lot, growth has slowed so that is hurting equity flow.
You are right you haven't had a lot of equity outflow but when you have a deficit you need persistent inflow just to stand still. If equity flows are flat, no inflow, no outflow and fixed income flows are flat, the currency is going to weaken. So RBI needs to create an environment which is conducive for large inflows.
For equity that is going to be tough because the economy is slowing that means really it is going to have to be fixed income and for that it needs to have a monetary policy regime that provides attractive yields and pulls inflation down faster than it has been falling so far. Q: Consensus estimates on GDP have already started coming down. We started the year with expectations of 6 percent. Many economists are talking about 5.5 percent. If these measures perhaps last for the next three months do you see a downside risk to expectations of a 5.5 percent GDP? Might we go towards 5 percent mark as well? Chakrabarty: It is possible. We have begun the year with four factors that could drive growth marginally higher than last year. One was softening of interest rates, two was the global economy was looking relatively better, three was better monsoon and four was some kind of spending on the back of elections. Out of these four, two seem to be out of the window now and that is why clearly the kind of conviction that we had on somewhat higher growth in FY14 compared to FY13 seems to be coming down quite a lot.
It is difficult to really pinpoint the effect of somewhat higher lending rates on investment activity when investment activity is already at almost a bottom. But still I believe that we will probably be looking at revising growth numbers if these measures persist for more than three months. Q: As a person who probably will be advising debt funds and investing yourself what is your sense, if the rupee stays south of 64 the next few weeks and the yields are where they are now, on the 10-year you are getting about 8.5 percent, is this enough for FIIs to bite? Would you see FII fund flows at least in the debt bucket coming in? Farris: Last week we recommended that investors sell dollars and buy rupee tactically and that was really just ahead of some of the measures. The first round of tightening that the RBI announced. We thought they would do an NRI bond issue, instead we got interest rate tightening. It has been a bit patchy since then, but given yesterday's measures it certainly seems like the government is committed to keeping the rupee below 60.
So we have maintained the recommendation to sell dollar, own rupee and earn the carry, but what would be crucial to our forecast and maintaining that recommendation will be consistency in RBI policies. RBI keeps the rate structure higher, inflation clearly starts to come down faster and the current account balance is improving faster. All of that will argue for a more constructive currency outlook as it would anywhere in the world. Q: You keep speaking about rates being consistently higher. Do you see the possibility of perhaps a CRR hike or more measures by the RBI to tighten domestic liquidity? Farris: All those things are possible. I am not necessarily forecasting any of that. What they have done so far could work. They could just easily rely on Open Market Operations (OMO), drain liquidity from the system or they could use CRR hikes. To my mind how they get to the objective of tightening liquidity having a higher rate structure that changes inflation expectations and helps to improve the current account balance is immaterial. What is most important is simply that they do it and be consistent about it. Q: How have you interpreted this action, would you say that this 10 quarter overnight regime is likely to remain for two-three months for the RBI to drive home the point? Gambhir: As far as we are concerned we were anticipating something of this nature to happen. The market was talking about a CRR hike or something. The whole point was that the earlier set of measures that they announced because they did not follow-through with the acceptance of the Open Market Operation (OMO) auction, it created some kind of liquidity positivity in the market and the call rates were not really going up to the level which they probably wanted.
So I see these measures are basically as a follow-through of what they did earlier to make sure that the overnight rates stick to 10.25 and create a little above 10.25. How long these measures will last, it is a question of when RBI is able to come to a judgement that the objective with which they initiated these measures has been achieved.
Now the question is whether they want appreciation in the currency or they want less volatility in the currency. If you are talking about appreciation in the currency then I think it is a tougher task. Many more things need to happen before you see that. So the timeline for these measures to be there in the market could be a little longer than what has been telegraphed so far. I do feel that we need to see this for a period of about two-three months at least for it to start becoming effective. Q: We have seen the 10 year bond yield go up quite a bit just at the end of May it was hovering at levels of 7.11-7.15 and today it almost went to that 8.5 percent, what is it factoring in by way of more measures by the RBI? Gambhir: The whole interest rate curve is going to readjust to the new reality of 10.25 percent overnight call rate or even higher overnight call rate. We will see an inversion in the yield curve and the biggest problem for the market right now is given the fact that the access to liquidity adjustment facility (LAF) window has been restricted to small amount of 0.5 percent of their NDTL for each bank, essentially any bond holdings that you have are going to get refinanced at a higher rate of near 10.25 percent which means that it is very expensive now to hold these bonds in the trading books and we are seeing an impact of that on the market.
If these measures persist for a longer period of time and you see overnight fixings to be higher around 10 quarter, you will see the bond yields to continue to edge higher. I do feel that we will revisit that 8.5 percent that we saw in the morning and we will probably go higher than that as well if we continue to trade in the overnight rate. Q: You have been at the treasury helm of a very large bank not so long ago. What is your sense? When does it tip over into higher deposit rates and lending rates, especially as both you and Samiran have been talking about the measures persisting for a couple of months? Gambhir: I think it will start biting very soon. I do not think it is going to take much longer. The reality is that the moment you start paying 10 percent or higher rate in the call money market and if you are funding yourselves through the Liquidity Adjustment Facility (LAF) window and if the deposit rates are lower at around 9 percent or so you will obviously start bidding for more deposits.
So I do feel that as far as the short-term deposits are concerned, deposits uptil 1 year are concerned I think this will start filtering through pretty fast. Even today we have seen March Certificates of Deposit (CD) getting traded at about 10-10.25 percent, even though they may have come down a little bit now, but it is clearly starting to get reflected in the shorter end of the money market curve, especially the CD curve and once you start having CDs traded at about 10-10.25 percent deposit rates cannot be far away. Q: Is there any need for a repo hike or a CRR hike on July 30th? Effectively the measures have pushed short-term rates higher without signalling any structural change in monetary policy. Would July 30th be important only to read the RBI's mind or do you expect action as well? Chakrabarty: RBI has been refraining from using the repo and CRR just because it has a signalling element of permanency into it, at least that is how RBI reads it, that is how probably market reads it. That is why you are seeing one after another measures coming in which are supposedly temporary and signals that way. So in that sense I do not think that we will see an actual repo rate hike or a CRR hike on the 30th, but at the same time we cannot completely rule out any further measures to tighten liquidity if these measures are also not sufficient to bite.
_PAGEBREAK_ Q: What is the possibility of rupee strengthening perhaps for the short-term, say up until the next three months or so on the back of all these measures by the RBI, but starts weakening closer to the end of the year by December on account of the external situation, the Fed tapering and therefore the dollar strength and on account of that perhaps we are left with a weak rupee. Rupee once again starts moving towards the 60 mark by year end and plus a weaker growth outlook. Chakrabarty: In the very short-term what we have seen is that because bond yields have shot through the roof a lot of FII holdings' stop losses have been hit and they have been forced to sell. We are now probably going to see some interest in FII buying with these kind of levels on the debt side, but at the same time we worry that if there is a perception in the equity market that these rate hikes are going to stay then we could see equity outflows. In the last 45 days or so we have seen about USD 3 billion of equity outflows which is small compared to the USD 15 billion that we received earlier in the year, but it is still a sizable number.
Then comes the question of how quickly does the current account correct? In our view for the full year the CAD is going to be about USD 75 billion, about USD 15 billion lower from last year. This is not yet completely priced in the market. If this number is around that USD 70-75 billion mark then progressively we are going to see trade deficit numbers monthly in the range of USD 10-12 billion which could provide some comfort to the market. The big question mark really is whether are we going to get enough FII flows on equities throughout the year given that global liquidity is likely to get tightened. Q: Do you see an NRI bond as inevitability and what should its design be, how much should it pay for investors to bite? Gambhir: Equity flows and fixed income flows are driven by very different considerations, we all know that. So equity guys are a little bit more sensitive towards growth and the fixed incomes guys are really looking at the yield differentials and the carry.
As far as equity flows are concerned there is a serious concern that if we do see growth heading lower and the expectations around growth starting to bite, we could see concern around that segment. As far as fixed income is concerned I think a lot of the flow is driven by the carry considerations and the interest rate differential considerations. Lot of the FII flow which comes is also on a hedged basis which means that people look at the net spread that they earn after hedging in the forward market.
Now the paradoxical situation here according to me of these measures is that if you really want the speculative pressure on the rupee to go away then you need to make sure that the forward premia are at a fairly high level so that the exporters which have been holding back on selling the rupee actually come into the market and sell.
However, if the forward premia actually jumps beyond a certain point then the entire increase in the interest rates that you have engineered in the short-term of the curve just gets withered away in the hedging cost. So from an FII stand point the interest rate differential still is not attractive enough. So it is a little bit of a chicken and egg at this point in time, we need to see where exactly the market settles to take a call on whether the spread differential will be good enough for the FII flow to start resuming.
As far as the NRI bond is concerned we will probably need to access the offshore bond markets in one form or the other whether it is sovereign bond or an NRI bond. I think there are relative merits and demerits of each of these instruments. I personally feel that you can access much longer term money in a sovereign bond market and you can go up to 10 or even 30 years in terms of 10 year in the sovereign bond markets.
So at some point in time India needs to make an attempt to reach or get that kind of liquidity. We clearly need to have a much more stable rupee and a much more stable currency before we can do that. So in the interim I do feel that it is possible that they might want to do an NRI bond of some form. I don't think more than USD 5-10 billion can be expected at this point in time but that is a start and that could start giving markets some kind of comfort that there is additional money, liquidity that is going to flow in. Q: Do you expect any action on July 30th from RBI? Gambhir: I do not think so at this point in time. I think July 30th is just going to be a signalling of the intent of continuation of these measures, but per se I am not expecting a CRR or a repo rate hike. Chakrabarty: I agree with Neeraj. At best I can expect some guidance on how long these measures are going to stay by defining the framework under which RBI is working.