Monetary tightening to have limited impact, RBI should recoup forex reserves for rupee: BofA-ML

NEW DELHI: The Reserve Bank of India (RBI) will find it hard to defend the rupee at 60 versus the US dollar, says Bank of America Merrill Lynch ( BofA-ML) in its report. "We continue to believe that the RBI will have to recoup foreign exchange reserves - rather than hike rates - to restore confidence in the rupee," says Indranil Sen Gupta, India Economist, DSP Merrill Lynch (India).

The RBI will eventually take more proactive steps to recoup foreign exchange reserves to make up for not buying FX during 2H09-1H11, the bank opines. "Monetary tightening typically has a limited impact on the rupee largely because parity-driven theories do not, in reality, work very well for India," the bank says

"This is because the $250 billion FII equity portfolio, which responds to growth, is much larger than the $35 billion FII debt portfolio, which responds to rates," it explains.

According to the bank, the import cover has halved to 7 months - last seen in 1996 - in the past 4 years. This is well below the 8-10 months needed for rupee stability.

The bank estimates that RBI will be hard-pressed to sell more than $30 billion to fend off contagion. "Yet, our balance of payments estimates do not suggest that it will be able to buy FX beyond extinguishing their forward book (of $5 billion left) in the normal course."

It is for this reason that the bank expects RBI to raise Foreign Exchange NRI or sovereign bonds. "While hikes in FDI limits for telecom and other sectors are positive, in our view, their impact on the balance of payments will take some time. Although there is talk of hiking FII equity limits in PSU banks, many of them already have counters open," the bank says. BofA-ML has suggested more immediate policy measures such as

NRI bonds: Re-issuing 7-9% 5-year FX-denominated non-resident Indian bond such as the 1998 Resurgent India Bonds or 2001 India Millennium Deposits that raised $5 billion each and stabilized foreign exchange markets. The bank estimates that this could fetch about $20 billion.

Listing Rupee sovereign debt in London and Singapore and issuing FX-denominated sovereign debt are also measures that the bank has recommended.

RBI's tightening will impact growth, although it is perceived to be temporary, Sen Gupta says. The bank has cut its FY14 GDP growth forecast for the economy to 5.5% from 5.8% earlier. "We had earlier expected growth to stage a shallow recovery to 5.8% on the back of better rains and lending rate cuts. We have now removed the 30 bps we had expected from softer rates," it adds.