Duvvuri Subbarao may prefer a one-two on Re, prices

All eyes are focused on the Reserve Bank of India’s announcement on interest rates on Tuesday. The stock market investors, in particular, are suffering from a bout of nerves.

While the general feeling is that a steep rate hike will dunk sentiment, there is another side to the story — of  the rupee.

Let us look at the chain of events that may unfold if the RBI does not tighten:
Raising rates will attract overseas capital, leading to inward remittances and a stable rupee.

Since India remains a net importer (crude constitutes a lion’s share of the imports), all landed prices become prohibitively high, leading to higher inflation. Letting the rupee fall by not raising rates will also eventually stoke inflation.

Sure, corporate profitability will get squeezed for a quarter or two, but over time, protecting the rupee is more important than buoying the stock indices.

If the rupee sinks past the 52.50 - 53.50 band, any temporary perceived benefit from not raising interest rates will disappear rapidly. Purchasing power of the people will erode and may lead to demand destruction and aggressive cost-cutting by corporates, including pay / job cuts.

The biggest risk from a depreciating rupee is India’s dollar-denominated debt, which will rise. Remember how Korea, Taiwan, Malaysia and Indonesia almost went over the cliff in 1997, as their external debt became nearly untenable due to a sharp fall in their local currencies?

Any rise in corporate, credit card and home-loan defaults will start sweating the banking sector as NPAs will rise. 

So it is important to buoy the rupee to avert any of the above unpleasant scenarios.

While stock indices are the barometer of the feel-good-factor (or otherwise) of the financial markets, the national currency is the barometer of the country as a whole.

In the circumstances, Duvvuri Subbarao may choose to land a one-two on inflation and rupee with a rate hike.    
    vijay@BSPLindia.com