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RBI surprises with its Monetary Policy (October 2018):
After two successive rate hikes, the RBI monetary policy committee surprised the market by keeping the key policy rates unchanged, citing a benign inflation trajectory and downward revision to inflation projection.
The committee voted 5:1 to keep the rates unchanged, with only Chetan Ghate, professor at the Indian Statistical Institute, voting for a rate hike.
The central bank also changed its stance from ‘neutral’ to ‘calibrated tightening’, indicating that there will not be a rate cut in the near future.
Markets react negatively to RBI's move to keep policy rates unchanged:
India’s benchmark Sensex plunged a third day in a row in October 2018, after the Reserve Bank of India’s (RBI) policy review disappointed investors— even as it left key rates unchanged.
The central bank failed to provide concrete solutions to stop the depreciation of the rupee and resolve concerns over non-banking finance companies (NBFCs).
Investors felt the RBI could have been more concrete in pronouncing measures to tide over the recent concerns over NBFCs.
Many NBFC stocks have eroded value over the past weeks after IL & FS defaulted on loan payments.
This, coupled with a liquidity crisis, has weighed on NBFC stocks.
What is the relation between interest rate hike and depreciating rupee?
The Indian rupee has been one of the worst performing major emerging market (EM) currencies in 2018, and the worst in Asia-Pacific.
The central bank has been raising interest rates to match the rising interest rates in the US.
If RBI does not raise interest rates, the “yield differential” with the US might narrow, potentially prompting more capital outflows from India and further weighing on the rupee.
The central bank’s rate hikes have, however, complicated matters for India’s banking sector, already reeling under a massive bad debt problem. With more hikes in the offing, the already low credit growth figures could dip further.
The slowing down of domestic credit flow had prompted many firms to borrow abroad, and external commercial borrowings (ECBs) had emerged as an important source of alternative funding for Indian companies over the past few quarters.
But the rupee’s fall will make even that option more difficult, as it has raised external borrowing costs.
Will the Rupee remain weak?
Given that the current account deficit is likely to remain under pressure, the rupee is likely to remain weak for some time, raising external funding costs for Indian firms even as it feeds into domestic inflation.
While almost all emerging markets have witnessed capital outflows amid interest rate hikes in the US, one pattern stands out.
Countries with higher current account deficit appear to have been penalized more.
The recent worsening of India’s non-oil trade deficit suggests that the current account balance is likely to be under stress.
With oil prices expected to remain high, the outlook on the rupee appears bleak.
What is the rationality behind RBI's decision to hold rates?
Unlike in 2013 round of rupee depreciation, which was driven by "idiosyncratic factors", the troubles for the rupee are driven largely by global factors in the current round (2018).
With currency weakness largely driven by global factors and the real rate cushion already quite high in India, monetary tightening is not necessarily an effective instrument for limiting currency depreciation.
The depreciation of the rupee has been moderate in comparison to several other emerging market peers.
By end-September 2018, the rupee had depreciated in nominal effective terms by 5.6 per cent since end-March.
In real effective terms, the depreciation has been 5 per cent.
The central bank adopted a textbook line: Both governor Urjit Patel and Deputy Governor Viral Acharya reiterated the MPC’s mandate was flexible inflation targeting and the interest rate is a policy tool to be used to achieve the 4 percent consumer price index inflation target.