Saturday, January 19, 2008

"CYA guys.. Now..!"

Ila Patnaik makes her case why RBI should be cutting interest rates right now. (hat tip : Ajay Shah)

Her theory goes so long as there is scope for arbitrage between interest rates in US and India, dollar inflows will continue to drive the inflation and Rupee up. This relationship between Rupee rise and inflation (owing to upsurge in dollar flows) in the Indian economy – where interest rates are higher than that in the US - creates an anomaly in that a cut in interest rates will not only help rein in inflation by slowing down $$ inflows, it will also arrest the surge of the Rupee.

Ms.Patnaik has this view that since US economy is sliding into recession, Fed has more reasons to cut US interest rates. I see that move could further sex up high interest destinations like India (for not just FII/FDI/ECB flows, but also to NRI remittances) and the deluge will only accelerate. Traditional methods that soak up liquidity viz. OMO by RBI, CRR hike etc., meant to rein in inflation and arrest the rupee rise will only add to inflationary liquidity in the system. In effect, a higher interest rate regime instead of containing inflation will end up exacerbating it.

So here you have a paradox. Normally when you cut interest rates, it could lead to inflation propelled by higher credit off-take. But in our peculiar economic situation driven by excess liquidity and a rising rupee, cutting interest rates can effectively arrest dollar deluge as well as the Rupee rise – the twin goals that RBI is struggling to achieve.

Sound argument. But I say the Indian borrowers of foreign currency (ECB/FCCB) in recent times have large bets on a falling dollar to benefit from the exchange rate arbitrage. I doubt whether our CFOs are equipped with rate sensitive AWACS that scan early symptoms… A sudden reversal in RBI stance could wreck many a business and could rock the stock market sentiment as well. So RBI should give out early warnings.

The least that RBI Guv Dr.Reddy could do is to signal them “CYA guys… Now !”

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