Indian two thousand rupee banknotes are arranged for a photograph in Mumbai, India. (Photographer: Dhiraj Singh/Bloomberg)

Continued Fall In Rupee Leads To Rate Hike Fears

The Indian rupee fell further on Tuesday and took bond prices down with it, as investors worried about the inflationary impact of a weaker currency.

The rupee closed at a record low of Rs 71.57 against the dollar, down 0.5 percent compared to Monday’s close. The rupee has fallen 2 percent in the last five days alone. This is, however, not out of line with peer currencies like the Indonesian rupiah, which has also seen a 2 percent depreciation.

The rupee fall, which was first seen as a healthy correction, is now leading to a fear of higher interest rates. Reflecting that concern, the 10-year benchmark bond yield rose to a four year high of 8.042 percent on Tuesday afternoon compared with Monday’s close of 7.999 percent. Bond yields and bond prices move inversely.

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The risk of imported inflation is keeping bond investors edgy, said Tushar Arora, senior economist at HDFC Bank Ltd. “We have a year-end call on the 10-year bond yield around 8.1-8.2 percent, and I think the trend seems to be moving in that direction,” he added.

India’s Monetary Policy Committee has hiked rates twice this year to 6.5 percent. Most economists were expecting a pause after the two consecutive rate hikes. However, with the currency continuing to weaken, some see the risk of another rate hike rising.

Continued Fall In Rupee Leads To Rate Hike Fears

The rupee has depreciated nearly 10 percent since March, owing to rising crude oil prices and the fear of a widening current account deficit. It is the worst performing currency in the Asian region so far this year.

What has added to the weakness is the perception that the RBI is intervening less to support the currency. A series of comments from government officials, suggesting that a weaker currency is beneficial for the economy have also led to a change in expectations in the currency.

Many now expect the rupee to trade in a band closer to 70-72 against the U.S. dollar.

R Sivakumar, head of fixed income at Axis Mutual Fund, said that over the last few weeks, the market has witnessed the RBI allowing the rupee to depreciate beyond what some would consider normal.

“If the RBI has changed its stance with respect to the rupee’s value, then that is bad news for the bond market,” Sivakumar said.

To be sure, should the RBI choose to intervene and curb the fall in the rupee, it has a number of tools at its disposal.

Forex reserves, at above $400 billion, are still adequate to cover more than nine months of imports. The RBI could also consider hiking interest rates to defend the currency - an option used by economies like Indonesia, said Arora of HDFC Bank.

Sivakumar pointed out that while the rate defence has not helped in supporting the rupee in the past, higher rates may be needed purely from an inflation standpoint if the currency continues to depreciate.

In extreme circumstances, the RBI and the government could look at options like schemes to draw in foreign currency deposits or open a special window to sell dollars directly to oil companies.

“Having said that, this is a very tricky situation for the central bank. On one end, if they intervene, it brings rupee liquidity in to the market and at the same time they have to maintain liquidity at the neutral level, being an inflation targeting bank,” Arora said.

Watch Ira Dugal explain the rupee fall to 71.53/$ and bond yield spike to 8.06%.