RBI hikes short term interest rates to support rupee

The Reserve Bank of India hiked short term rates late on Monday in the first strong measure to support the Indian rupee. These measures, aimed to curb the rupee's decline by tightening liquidity, came after Governor D Subbarao met Finance Minister P Chidambaram yesterday.

Here's what the central bank has done.

1) The RBI has increased banks' cost of borrowing short term money through the Marginal Standing Facility (MSF) rate and Bank Rate each by 200 basis points ( 2 per cent) to 10.25 per cent. The measure will make it unattractive for banks to borrow rupee (at cheap rates) and buy dollars (in the forward markets). This will reduce the pressure on the rupee.

2) The RBI has capped the amount banks can borrow from overnight markets to Rs 75,000 crore. This is aimed to suck liquidity from the system. This will prevent banks from taking speculative position in forward markets (will support the rupee).

3) The RBI will conduct Open Market Sales of bonds of Rs 12,000 crore on Thursday to further suck out liquidity from the system. Bond prices will fall and yields will rise. Higher yields will attract foreign investors in the debt market. FIIs have sold billions of dollars in the debt market ever since Fed Reserve Chairman Ben Bernanke signalled a tapering of the quantitative easing in the U.S. resulting in a 10 per cent drop in the value of Indian rupee. Net portfolio investments in India slumped to just $50 million in the three months to June from $11.3 billion in the quarter ending in April.

Market participants said the measures will give near-term support to the rupee.

"This could lead to some increased dollar inflows as overall interest rates in the economy will rise, but it could be temporary - that is, as long as these steps are effective," a dealer at a foreign bank told Reuters.

The RBI does not set a target for the rupee, which hit a record low of 61.21 to the dollar last week, but it does take measures to manage volatility.

However, the latest measures will weigh on long term interest rates. That's because banks may hike deposit rates to attract cheap funds, but the step will lead to higher interest rates driving up home and auto loan rates.

"These will come at a heavy cost to the economy as short-end rates will rise and that will make borrowing costlier and affect growth if these measures continue for long," A. Prasanna, economist at ICICI Securities Primary Dealership told Reuters.

Meanwhile, Prime Minister Manmohan Singh will discuss the proposal to increase Foreign Direct Investment (FDI) cap in sectors like telecom, retail and defence with his senior Cabinet colleagues later today.

Economist say liberalizing FDI rules will help attract foreign investment into the country, which is badly needed at a time when the rupee is the worst performing currency in Asia.

A weak rupee also poses political challenges for the government, seeking to win a third straight mandate early next year.

(With inputs from Reuters)