INR and RBI –History repeating itself? Barclays Capital,

INR and RBI –History repeating itself?
The Reserve Bank of India (RBI) delivered a surprise 200bp hike in the Marginal
Standing Facility (MSF) earlier this week, along with capping banks’ repo borrowing to
INR750bn and the announcement of the absorption of market liquidity through the
open market sale of government securities. The RBI’s moves were targeted to push
short-term interest rates sharply higher, thereby, making forex speculation costlier. A
similar strategy was adopted by the RBI in January 1998, immediately after the South
East Asian currency crisis in November 1997, to combat heightened forex market
volatility. We spot a few key comparisons between the RBI’s current moves vis-à-vis
those in early 1998.
Tightening in 1998 –Adeparture from the RBI’s stated easing bias
First, the RBI had been easing in the recent months despite their cautious rhetoric (75bp
repo rate cuts from January to April2013). The current hike can, thus, be seen as a departure
from the course of RBI action, albeit possibly on a temporary basis/in the near term.
Similarly, during late 1997, the central bank had clearly started monetary policy easing to
revitalise growth following a phase of high inflation, heavy monetary tightening and a slump
in growth during the mid-1990s. In fact, in October 1997, the RBI had explicitly guided for
the lowering of the cash reserve ratio (CRR) cumulatively in stages, to 8% from 10%, on
eight specified dates between October 1997 and March 1998. Thus, on both occasions,
while the domestic macroeconomic considerations prompted the RBI to remain growth
supportive, the meaningful deterioration in the macroeconomic backdrop got triggered
from external developments (the Asian crisis in late 1997 and the current possibility of QE
tapering), whichled to a quick switch in policy priorities of the central bank.
Tightening in 1998 was multi-layered, fast and furious
Second, the quantum of hikes in policy interest rates and/or in reserve requirement
(CRR) had been stark on both occasions. Similar to the hike in the MSF rate earlier this
week, the bank rate was hiked by 200bp on 16 January 1998 (to 11% from 9%).
Additionally, CRR was hiked by 50bp to 10.5% and the repo rate was raised by 200bp to
9% at the same time. Currently also, the measures relating to restricting banks’ repo
borrowing quantum and the announcement of the sale of government securities
through open market operations (OMO) highlight the focus on tightening liquidity by
the RBIto make hikes in policy interest rates more effective.
Third, bank rate –which was the key policy interest rate in the late-1990s –was hiked in
January 1998. Hiking the key policy interest rate was not the first step from the central
bank. Prior to that, the RBI had hiked the repo rate (which was an additional policy
interest rate during that time) sharply from 4.5% to 7% in three stages within a span of
less than 10 days (3-11 December 1997). It was, in fact, hiked again by another 200bp
to 9% on 16 January 1998. In the current phase, the RBI has so far not hiked the repo
rate – which is the key policy interest rate in the RBI’s current monetary policy
framework. It is important to note that we do not expect any hike in the repo rate in the
current round. Such a move would not necessarily enhance the probability of effectively
curbing pressures on the INR, in our view, since it could further dent FII flows into India

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RBI tried boosting foreign deposits, discouraged imports
Fourth, while the central bank had been hiking reserve requirements on banks’ domestic
deposit liabilities to make INR liquidity dearer during 1997-98, there were moves to waive
reserve requirements (CRR) on banks’ forex-linked deposit liabilities such as NRE and NRNR
deposits to boostforex inflows. Apart fromthe liberalisation in NRI deposit rates in 2011, we
have not seen any material benefit being offered to banks along similar lines recently. More
relaxations in the case of liabilities, which lead to forex inflows into the banking system –
such as NRE, FCNR – cannot be ruled out in the coming months, in our view.
Fifth, the RBI reduced interest rates on export credit on multiple occasions during 1997-98.
However, in December 1997, they had imposed an interest rate surcharge of 15% on the
lending rate on bank credit for imports, which was subsequently hiked to 30% in January
1998. Such measures were intended to influence external trade, and, thereby, were an effort
to reduce the country’s trade and current account deficits. Recently (June 2012), we have
seen the RBI enhancing export credit refinance limits for the banks. Additionally, there had
been a series of measures by the RBI and the government to reduce gold imports, which
had been a key source of expansion of India’s current account deficit in recent years.
The tighteningwas temporary – In place for two to four months
Sixth, the easing in the monetary policy tools started on 17 March 1998 – about a couple of
months after the sharp tightening in mid-January. The bank rate was eventually brought
back to the pre-hike level of 9% by 29 April 1998. The hike in CRR in January 1998 (200bp)
was partially undone by April 1998 (by 100bp, to 10%). If the 1998 experience is taken as
guidance, the current phase of stark monetary tightening should also be temporary. Against
the current weakness in economic momentum, we expect the recent spell of tightening by
the central bank to be reversed by Q4 13.
The tightening in 1998 was clearly more effective; FII outflow possibility a
key risk in 2013
Seventh, the immediate effect of the policy tightening in 1998 on near-term interest rates –
such as the call money rate – had been more pronounced. The weighted average call money
rate shot up to nearly 30% in January 1998 from an average of around 7% in Q4 97. On
some of the specific days in January 1998, call money rates even breached 100%. The effect
of the 1998 shock in curbing forex market speculation had, thus, been very effective. On the
other hand, given the presence of the framework of the policy rates corridor in recent years,
the MSF rate acts as a natural anchor for the interbank call money rate. Accordingly, even
after the sharp tightening in policy tools earlier this week, call money rates remained
anchored mostly at 8-9%.
A critical difference between the economic scenarios in 1998 and 2013 is the wide
difference in FII investments in India, particularly in the equity market. Such investments
used to be miniscule in 1998, which, on the other hand, is in the vicinity ofUSD200bn today
(in the BSE500 companies). Any disorderly adjustment in the economy at the moment
following the RBI policy shocks, thus, carries a far greater risk of FII sell-offs today.
Accordingly, the recent RBI moves do not ensure an effective curbing in pressures on the
INR, in our view, since they can potentially lead to FII outflows, especially in the current
backdrop of a prolonged phase of weak growth. Therefore, we believe that the recent RBI
measures are not enough to stabilise the INR. Our currency strategists feel that there are
now greater risks around our near-term USD/INR forecasts of 59 in 1m and 58 in 3m,
unless the recent RBI measures are followed with further actions to boost forex inflows in
the near-term.

Supporting INR needs more policy initiatives…
It would, thus, be appropriate for the RBI and/or the government to follow up with more
tangible measures to curb INR weakness. The absence of the same potentially carries the
risk of turning the current RBI initiatives counter-productive. RBI Intervention in the forex
market may yield some knee-jerk benefits. However, with shrinking forex reserves, the
central bank’s ability to intervene on a more prolonged basis has been reduced considerably
recently, in our view (see India: Foreign reserves - Weaker bench strength, 10 July 2013).
… with FX-denominated offshore bonds being the most potent near-term
option
Eventually, in August 1998, Resurgent India Bonds (RIBs) were floated overseas, targeting
the Indian diaspora by the State Bank of India. This issuance managed to raise USD4.2bn in
three currencies (USD, GBP, and DM). This turned out to be a meaningful accretion to
India’s forex reserve pool and eventually offered good support to the INR trajectory.
Amid the various potential policy options today, a scheme of FX-denominated offshore
bonds/deposits (likely targeting the Indian diaspora) remains the most potent near-term
policy option, in our view (see India: Arresting INR's fall - policy options, 11 June 2013). India
has tested this option several times (1991, 1998 and 2000) with reasonable success. Given
that such measures had earlier been adopted in various political regimes (1991: Congress;
1998 and 2000: BJP), political backlash will likely remain limited if such a scheme is
implemented. A high interest rate on the FX-denominated bonds and a de facto guarantee
from the Indian government were keys to these bonds’ success These bonds could be
permitted to be used as collateral for obtaining bank loans (thereby, making leveraged
investments possible).
We believe such a bond/deposit scheme could garner USD15-20bn relatively quickly, which
could effectively address concerns over funding India’s FY13-14 current account gap.
Additionally, it could trigger a reversal of part of the recent FII bond outflows (over USD8bn
since mid-May).

RBI Policy Chronology Summary 1997-98
Period/ date RBI policy measure Macroeconomic backdrop
Easing bias prior to South East Asian Financial Crisis
October 1997 Bank rate was reduced to 9% from 10%
RBI promised to reduce CRR to 8% from 10% in eight tranches between October
1997 and March 1998 (estimated liquidity infusion: INR96bn)
Interest rate to banks on CRR balances was raised from 3.5% to 4%
Interest rate on pre-shipment export credit was reduced to 12% from 13%. Post
shipment rupee credit interest rate reduced to 11% or less from 13% (both for
loans less than 90days)
RBI had started monetary
easing to revitalise growth
following a phase of high
inflation, heavy monetary
tightening and a slump in
growth during the mid-1990s
Stringent tightening following the South East Asian Financial Crisis
November 1997 Interest rate on post-shipment INR export credit (3-6m) was raised to 15% from
13%
CRR cuts planned through eight tranches was deferred
RBI announced scheme of the fixed repo rate starting at 4.5%
December 1997 CRR was raised by 50bps to 10% and Incremental CRR of 10% on NRE and NRNR
was withdrawn
Repo rate was raised in three stages during December alone to 7% from 4.5%
Banks were required to charge a 20% interestrate on overdue export bills
An interest rate surcharge of 15% on the lending rate imposed on bank credit for
imports
Interest rate on post-shipment INR export credit for over 90 days was reduced to
13% from 15%
January 1998 Bank rate was raised to 11% from 9%
CRR was raised to 10.5% from 10%
Repo rate was raised to 9% from 7%
Export credit refinance limit was halved to 50% of the increase in outstanding
export credit
Liquidity support to primary dealers via reverse repos was made discretionary
Interest rate surcharge on bank credits for imports was raised to 30% from 15%
General refinance to commercial banks was reduced to 0.25% of the fortnightly
average outstanding aggregate deposits in 1996-97.
Reversal of the RBI’s stringent policy stance
March– August 1998 March: Repo rate reduced to 8% from 9%. Bank rate was reduced to 10.5% from
11%. CRR was reduced to 10% from 10.5%
April: Bank rate was reduced to 9% from 10.5% in two stages; repo rate was
reduced to 6% from 8% in two stages
Export credit refinance limit was restored to 100% (versus 50% in the recent
past).
Interest rate on pre-shipment export credit (less than six months) was reduced to
11% from 12%
June 1998: Repo rate was reduced to 5% from 6%
August: Resurgent India Bonds (RIBs) were floated overseas targeting the Indian
diaspora by the State Bank of India – raises USD4.2bn in three currencies (USD,
GBP, DM). This turned out to be a meaningful accretion to the nation’s forex
reserve pool and eventually offered good support to the INR trajectory
Reversal of monetary policy
measures announced to contain
effects of South East Asian
currency crisis. Stability had
returned to currency market
and liquidity conditions eased
Source: Reserve Bank of India, Barclays Research

India not alone in the volatility boat
The financial market volatility in India is not isolated. Within emerging markets, high
yielding economies with relatively larger twin deficits and high external financing
requirements have been struggling with market volatility, and have seen their currencies
weaken substantially since mid-May. Among the more prominent ones, Turkey, Brazil and
Indonesia have suffered the same fate as India. Their yields have moved higher, currencies
have weakened as vulnerability of these EM economies to lower global liquidity started
coming to fore. But they too have responded with policy measures, somewhat similar to the
one that India has adopted.
Brazil: The central bank in Brazil has hiked its policy interest rate by 50bp,to 8.50%, and has
indicated that the tightening cycle is likely to continue. Further, the central bank and
policymakers have been relaxing capital control measures that were implemented post the
start of the QE, and the latest measure came in late June. The central bank removed reserve
requirements on short spot USD positions – local institutions collected a 60% reserve
requirement on short USD positions that exceeded USD3bn. This came three weeks after
the government reduced the IOF tax on foreign fixed income flows to zero from 6% and
announced the end of the 1% IOF tax on onshore USD derivatives transactions.
Indonesia: Policymakers have undertaken several measures to address the growing
macroeconomic imbalances. It started with reduction of fuel subsidies, which pushed up
inflation. To temper credit growth and manage inflation expectations, the central bank
imposed macro prudential measures on credit disbursement to the property sector. To
support the currency, the central bank has also raised its policy rate by 50bp in July, and
75bp cumulatively. Our economist expects more rate hikes by the central bank in the
coming months.
Turkey: The Central Bank of Turkey has been using FX intervention to stabilize the TRY, but
it has had limited success. Similar to India, Turkey's external financing outlook faces
challenges and the central bank’s reserves are quite limited in comparison (even relative to
India). Our economists think that the Turkish central bank may need to shift the interest
rate corridor (now 3.50-6.50%), or at least its ceiling, by 200-250bp. Indeed, the central
bank has recently indicated its willingness to raise the top end of the corridor, something
the RBI has already implementedthrough the hike in the MSF rate