ANALYSIS - India unleashes rupee to knock out inflation

The Reserve Bank of India (RBI) appears to have stepped out of the way of a rising rupee, after buying almost $20 billion in four months trying to cap it, and is instead using the currency's strength to help fight inflation.


Analysts say the rupee may have run out of steam for now after hitting a nine-year high of 41.62 per dollar this week, and the next step in the anti-inflation offensive could be controls on raising external debt, possibly in a policy review next week.


When inflation is high - it hit a two-year peak of 6.7 percent in early 2007 -- intervention makes it even harder for the central bank to contain price pressures, and analysts think this may have prompted a shift in the stance on the rupee.


"Keeping the currency weak exacerbated inflationary pressures so you got a vicious cycle," said Shahab Jalinoos, currency strategist at ABN AMRO in Singapore.


The partially convertible rupee has risen around 6 percent this year, with most of the gains coming in the past five weeks as, traders say, the central bank has become less active in the market.


The RBI bought $19.7 billion in the four months starting November, including a record $11.9 billion in February, trying to block the rupee's rise, latest data shows.


Both ABN and UBS see the rupee now retracing to 42.20-42.50 - although UBS expects intervention to be a factor while ABN sees it weakening on profit-taking after the recent surge.


CIRCULAR PROBLEM

Worried about a widening trade deficit and fearing a sudden destabilising reversal of capital inflows, the central bank had kept the rupee in a broad range of 43-47 per dollar for the past three years by intervening whenever it neared those limits.


When the RBI sold rupees for dollars, it added funds to the local banking system - fuel for the rampant credit and money supply growth it was trying to rein in with interest rate rises.
To counteract that, the RBI has impounded some of the banks' lendable funds through three reserve increases since December and also by selling bonds.


But the measures created short-term cash shortages, which banks overcame by selling dollars to raise rupees - adding to the pressure for the currency to rise.


An added problem is that foreign investors are also buying rupees to invest in the fast-growing economy either via stocks, property, new factories or promising small companies.


Domestic firms have been exploiting lower interest rates overseas to fund expansion, raising $9.1 billion of debt between April and December, all of which led to huge inflows, higher demand for rupees and more intervention.


A.V. Rajwade, a member of an official panel on capital account convertibility, said not only was the RBI nearing the limit of intervention that it could absorb by issuing bonds, it also could not keep jacking up the cash reserve ratio (CRR).


"The CRR is a very blunt tool and hurts smaller banks more," Rajwade said.


ALTERNATIVE MEASURES


Nine out of 14 economists polled by Reuters do not expect the central bank to raise its key short-term lending rate at its April 24 review. The lending rate has been increased by 125 basis points in five moves since early June last year.


But many think the central bank is not done tightening policy and its next step could be short-term, targeted capital controls.


Chetan Ahya, economist at Morgan Stanley, said the RBI could moderate certain types of inflows if they surged further.


"For instance, it could reduce the limit on the amount of external commercial borrowings that can be raised by the corporate sector during a year," Ahya said.


The central bank caps external commercial borrowings, known locally as ECBs, at $22 billion per financial year, and companies and banks can bring in $500 million without asking permission.
It was unlikely the RBI would go as far as Thailand, which in December required a percentage of foreign speculative inflows to be held interest-free for a year at the central bank.


"The central bank would be wary of putting capital controls in terms of foreign investments as it would have a big repercussion on the stock markets," Rajwade said.


But short-term limits on ECBs could reduce capital inflows without hurting portfolio or foreign direct investment flows.


"I don't think it's a great idea. If you're genuinely worried about the currency it makes more sense to try to find ways of encouraging local money to leave as an off-setting factor," ABN's Jalinoos said.


The government says it needs infrastructure investment of $350 billion over the next few years to build better roads and ports and to overcome growth-stunting supply bottlenecks.
"India needs foreign money, so turning off the taps may not be a good idea in terms of a long-term growth opportunity - but as a short-term measure it's a possibility," Jalinoos said.