Changing Contours of Monetary Policy in Emerging Markets

In recent months falling Rupee has been a major concern for Central Bank of India. The Central bank has tried available instruments to defend the Rupee without giving any particular value that it may be defending. Giving a signal to the market about any particular exchange rate that central bank is defending may turn disastrous for Central bank and RBI has acted smartly. Central Banks in emerging market normally raise interest rates to defend depreciating currency (As Brazil has done recently). An Increase in interest rate slows down the flight of capital and higher interest rate also brings new investor. Unfortunately, RBI was not in a position to raise interest rates because of declining GDP growth rate and rising skepticism about the future growth story of India.

In the given circumstances, RBI is trying to reduce liquidity in the system (When RBI is injecting money we call it liquidity deficit phase and when it’s sucking money it’s called liquidity surplus phase) as there is evidence that Rupee appreciates in deficit phase. Second reason, for reducing liquidity was to make rupee scarce relative to the dollar and also to prevent speculators in taking positions in foreign exchange market. If speculators believe that the exchange rate is going to depreciate further, they can use Rupee to buy USD now and later on they can convert those USD in Rupee at a higher rate making a profit.

RBI kept its policy rate (Repo rate) unchanged (7.25 %) but raised the marginal standing facility (MSF) rate by 200 basis points (10.25 % Now). But it reduced the amount of borrowing through repo window from 1% of NDTL (Net Demand and Time Liabilities) to 0.5% of NDTL. Borrowing up to 1% of NDTL is allowed at MSF rate. The important point I’m trying to make is that RBI tried its level best to not raise interest rate by leaving policy rate unchanged so that it doesn’t create any problems for already declining growth.

Interest Rates in India

But if you see the interest rates in the figure above the interest rates across the board has risen and not only short-term interest rates. (If we believe in expectation theory then long term rates are average of short-term rates and rise in long-term rates means market is expecting higher short-term rates in future). The rise in long-term rate is the worst thing that RBI would have been expecting in such times (Investment and Durable consumption responsible for growth are dependent on long-term rates).

RBI wants higher short-term rates but can’t afford these higher short-term rates being propagated to higher long-term rates. RBI has started doing Operation Twist (Operation Twist is basically changing the maturity composition of government bond held by the general public in a manner to affect yield in the desired direction). RBI is selling short-term treasury bills thus making the prices of treasury bills lower and increasing yield on that and at the same time has started buying long-term government bonds, thus increasing their price and decreasing yield on that.

It’s really interesting that to avert the problems created by Unconventional Monetary Policy of Federal Reserve Bank (Federal Reserve bought huge amount of long-term bonds to reduce the long-term yield to support economy when short-term rates touched zero bound, and people are claiming that since federal reserve is going to wind up quantitative easing in near future because of improving condition of US economy, the funds are flowing back to US leading to sharp depreciation of Rupee) the Reserve Bank is trying its hand on Unconventional Monetary Policy. Let’s see whether RBI is able to reduce the long-term rates or not.

Originally published at on September 1, 2013.

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