Rupee is the new villian in way of RBI lowering interest rates

The looming threat of imported inflation has prompted Reserve Bank of India (RBI) Governor Duvvuri Subbarao to stay away from lowering interest rates.

This is despite the wholesale price index-based inflation easing to 4.7 per cent in May 2013, down from an average of 7.4 per cent in 2012/13. The repo rate, at which the RBI injects liquidity into the banking system, remains unchanged at 7.25 per cent while the cash reserve ratio (CRR) stays at 4 per cent.

Clearly, the rupee has now emerged as a new villain in the way of cutting interest rates. A weak currency translates into higher cost of imports by way of oil and other essential items. Indian companies also import machinery and raw materials, which pushes the prices of final goods higher.

The rupee has slumped close to 59 levels against the US dollar. It has slipped nearly 6 per cent against the greenback since the start of the financial year in April. It plummeted 6.6 per cent in the past three weeks.

In the past five years, the rupee has plunged nearly 50 per cent, which shows how imported inflation has been playing havoc with the country's financial system. A weak currency doesn't give any relief even if prices of imports, say crude oil, fall.

The sustained depreciation in the rupee is due mainly to an outflow of dollars and a lack of momentum in capital inflows by way of foreign institutional investment in stock markets and also through foreign direct investment, which is more of a permanent capital.

If one looks at the currency depreciation and its impact on fuelling inflation, there is no headroom for the RBI to reduce interest rates in coming months.

The RBI has warned that while several measures have been taken to contain the current account deficit (CAD), there is a need to be vigilant about global uncertainty, the rapid shift in risk perceptions and its impact on capital flows.

Still, there are some who say the central bank shouldn't be worried about the rupee at this moment because the bigger threat is falling economic growth.

In May, the Central Statistical Office estimated gross domestic product (GDP) growth at 4.8 per cent for the fourth quarter of 2012/13. Falling inflation and lower growth is a clear indicator for reducing interest rates and spur growth. If growth comes back, there is a likelihood of foreign capital flowing into the country.

In the days to come, more clarity will emerge on how the government and the RBI plan to stabilise the rupee. If they succeed, there is every likelihood of the RBI continuing with the task of softening the interest rates.