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By HaleStewart October 29, 2013 8:50 am
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India Raises Rates To Curb Inflation and Defend the Rupee

Today, the Reserve Bank of India raised interest rates an additioinal 25 basis points.  To place this decision in context, consider the following three charts:

Overall growth has been slowing.  In 2010, the annual rate of GDP growth was very high, printing at over 9%.  However, the overall pace is now slowing, printing at about half the 2010 level.

Inflation is high and increasing.  

For most of 2012 and early 2013, the inflation rate was consistently over 6.5%.    While the rate dropped earlier this year, it has since picked back up, increasing from 4.5% to 6.5%. 

Finally the rupee has been weakening in the international markplace.  Here' s a chart of the Bank of International Settlement's effective exchange rate for the rupee:

Overall, the rupee has clearly been declining.  While this is export positive (see below) it is inflation negative. 

The above three data points place the central bank in a bind; if they raise rates to lower inflation and protect the currency, they will also slow growth.  Conversely, if they keep rates steady or lower them, they allow inflation to increase and the rupee to decrease in value.  Adding to the complexity is India has a new Central Bank head, and he needs to establish himself in the market.  Raising rates indicates he clearly wants to establish himself as an inflation hawk.  In the long run, this is probably his best bet, as his moves today will prove useful in establishing the interest rate narrative tomorrow.  Put another way, establishing yourself as an inflation fighter creates the impression for market participants that you're a hawk, which thereby lowering inflation expectations over time.

The following is from the Central Bank's Policy Announcement:

Our policy decisions are based on a detailed assessment of the global and domestic macroeconomic situation. The outlook for global growth has improved modestly and the prospect of delay in the taper of the Federal Reserve’s bond purchases has brought calm to financial markets.

Domestically, while industrial activity has weakened, strengthening export growth, signs of revival in some services along with the expected pick-up in agriculture could increase the real GDP growth from 4.4 per cent in Q1 to a central estimate of 5.0 per cent for the year as a whole. The revival of large stalled projects and the pipeline cleared by the Cabinet Committee on Investment may buoy investment and overall activity towards the close of the year.

On inflation, both wholesale and consumer price inflation are likely to remain elevated in the months ahead, warranting anappropriate policy response.

The delay in the Fed's tapering program will help to slow foreign capital withdrawals from India, thereby (hopefully) slowing the rupees decline.  While industrial production has been fluctuating between positive and negative readings, exports have been picking up.  The latest HSBC services reading was decidedly negative: 

Down from August’s 47.6 to 46.1 in September, the HSBC India Composite Output Index declined to its lowest mark in four-and-a-half years to signal a sharp deterioration in business activity across the country’s private sector. Whereas the fall in manufacturing production eased, service providers recorded an accelerated decline in output.

Overall, the macro-level picture does not look that promising, although the bank clearly feels there is enough potential growth in the pipeline to withstand a rate increase.  To that end, inflation is clearly the top concern of the bank, with its overall increase supporting the decision to raise rates.

Hale Stewart is a former bond broker who has been writing about economics and financial markets since 2006 on the Bonddad Blog.  He is also a tax attorney with a domestic and international practice while also forming and managing captive insurance companies for US companies.   You can follow him on twitter at:@captivelawyer



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