While it seems that RBI is not going to hike or cut
tomorrow, one of the point which always remain contentious is whether INR
appreciates or depreciates in response to movement in interest rates.
Contradictory to traditional currency/interest rate
correlation, USDINR reacts to interest rates moves more from a growth and
capital account perspective, as INR is not freely convertible to make good of
rate related arbitrage. A rate hike often follows worries of rising inflation
and is generally seen as a move to curtail growth. While a rate cut is seen as
growth positive helping equity and bond market valuation and thereby attracting
capital inflows.
Empirical evidence also suggests the above observation
(chart below). In the early 2000s when rates in India came off sharply, INR
appreciated led by robust growth and capital inflows. As rates were increased
from 2005 and growth started peaking out we again saw INR losing till 2009. The
period from 2009 to 2011 saw USDINR coming off from the crisis peaks and the
central bank supporting growth through aggressive rate cuts like elsewhere
globally. Post 2011 was a period when India’s twin deficit started raising its
head and 2013 saw interest rate confusion or policy missteps due to taper
tantrum in the US. During this period INR continued to depreciate sharply while
rates remained near the same. Post 2014, in spite of robust capital inflows and
stable growth, RBI stepped up its currency intervention / management and
ensured that INR does not appreciate too much while REPO rate was cut from 7.5%
to 6%. Then the latest run up in USDINR to 74 in 2018 coincided with rate
hikes.
Therefore the takeaway for me is that a dovish RBI is
supportive of INR gains and vice versa.
Although tomorrow rate action looks unlikely given arguments
on both sides, it seems that RBI will tend to be more dovish. This should
ensure that the up moves in USDINR remains limited to the top already created
at 71.80 while the chances of seeing 71 again increases significantly.
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