RBI’s move to curb Indian Rupee (INR) volatility will actually lead to more volatility for the currency. The Central Bank has basically pointed fingers at cheap liquidity in the domestic money markets as the cause of the record low levels of the INR against the USD.
RBI believes that markets are borrowing at repo rate of 7.25% in the LAF (Liquidity Adjustment Facility) auctions and using that borrowed money to go long on USD, which is the same as shorting the INR. RBI has now limited LAF amounts to Rs 75,000 crores (around 1% of NDTL or Net Demand and Time Liabilities) and has increased the MSF (Marginal Standing Facility) rate to 300bps over the repo rate of 7.25%. MSF was at 100bps over repo until the RBI moves.
RBI is also conducting an OMO (Open Market Operation) sale auction of Rs 12,000 crores on the 18th of July to suck out liquidity from the system.
RBI wants to make liquidity costlier in the system to make it unviable for speculators to borrow and buy the USD to profit from its strength.
The market is borrowing over Rs 90,000 crores in the LAF auction of the RBI and with the limit reduced to Rs 75,000 crores, borrowers will have to bid for funds from the market. MSF is a facility for borrowers who could not get funds in the LAF auction to borrow from the RBI at higher rates. RBI by tightening liquidity and raising the MSF rates is aiming to push up overnight money market rates (Call Money and CBLO) to over 10% levels.
RBI’s actions will lead to higher short term rates, higher long term rates, more FII debt sales and more weakness in the INR. Short term rates will rise on liquidity becoming costlier while long term rates will rise on OMO sales. Rising interest rates will prompt FIIs to sell more bonds and this will lead to INR falling and the cycle will continue.
RBI could have rejected bids for repo in the LAF auctions rather than taking such volatility inducing measures. Rejecting bids for funds in the LAF will make borrowers go to the market for funds leading to overnight money market rates trending higher on the back of higher demand for funds. However RBI has chosen to take a more complicate route to prevent INR volatility and this will most likely backfire on the central bank.