RBI Powerless on Rates as Swaps Show Deeper Crunch: India Credit

India’s incoming central bank Governor Raghuram Rajan has little room to use borrowing costs to spur Asia’s third-largest economy as the rupee plummets, interest-rate swaps show.

The cost to lock in rates for a year using the contracts surged 267 basis points this quarter to 10.16 percent yesterday as investors bet the Reserve Bank of India will prolong a cash crunch it created to shore up the currency. A similar rate in China was at 4.09 percent. The RBI said it will sell dollars to the nation’s biggest oil importers through a swap facility to stem the slide in the rupee, which plunged 3.9 percent yesterday to a record low of 68.8450 per dollar.

Rajan, who takes office on Sept. 5, will inherit an economy with a record current-account deficit, the highest inflation rate among the largest developing nations and company bond yields above 10 percent. Gross domestic product probably grew 4.6 percent last quarter from a year earlier, the least in four years, a Bloomberg survey showed before data due tomorrow.

“The liquidity steps taken by the RBI have led to a gut-wrenching credit squeeze, going in the direction of worsening growth,” Mirza Baig, head of foreign-exchange and interest-rate strategy in Singapore at BNP, said in an interview on Aug. 23. What Indian policy makers “are doing is having no effect, they’re losing their credibility and raising the risk of a rating downgrade,” he said.

Policy U-Turn

The RBI, which cut interest rates three times in the first half to support the economy, was later forced to abort its pro-growth bias and curb funding availability to stem the exchange-rate slide. Since mid-July, the central bank has raised two of its interest rates while keeping the benchmark repurchase rate at 7.25 percent, curtailed lenders’ access to cash and drained money from markets via open-market debt sales.

The tightening has led to the worst credit squeeze since the global financial crisis of 2008, with benchmark five-year company bond yields jumping 151 basis points since the end of June to 10.20 percent, data compiled by Bloomberg show. Three-month commercial paper rates rose 398 basis points to 12.40 percent. Company debt sales plunged to 1 billion rupees ($15 million) so far in August from 243 billion rupees in the same period of 2012.

UBS AG and BNP Paribas cut their growth forecasts for India this week as the funding crunch threatened to deter investments. Switzerland’s largest bank reduced its estimate for GDP gains in the year through March 2014 to 4.7 percent from 5.2 percent, while France’s No. 1 bank lowered its projection to 3.7 percent from 5.2 percent, according to separate reports.

‘A Hard Place’

The RBI will be unable to resume policies that support the economy until the rupee stabilizes, according to SJS Markets Ltd. The Indian currency has tumbled 19 percent this year, the worst performance among 24 emerging-market currencies tracked by Bloomberg, as the prospect of the U.S. paring stimulus boosted the dollar.

“The RBI is in a hard place,” Hemant Dharnidharka, the Bangalore-based head of credit research at SJS Markets, said in a phone interview on Aug. 27. “It can’t really support growth and the currency at the same time. It can’t cut rates because of the dollar and it can’t raise rates because of the slowing economy. So unless one of these two things stabilizes or begins to look up, the central bank can’t support the other.”

RBI Dollar Sales

The RBI will sell dollars to Indian Oil Corp., Bharat Petroleum Corp. and Hindustan Petroleum Corp., which the authority will repurchase after a specified period, according to a statement on its website. The measure, effective immediately, will extend until further notice and will be available to the companies through a designated bank. The rupee advanced 1.7 percent today to 67.67 per dollar following the central bank’s announcement.

The move will help reduce oil companies’ daily demand for foreign exchange in the spot market of as much as $600 million, according to Priyanka Kishore, a London-based currency strategist at Standard Chartered Plc.

The government’s ability to accelerate public spending and spur growth is also weakening as soaring debt costs threaten to worsen the budget deficit. Ten-year sovereign bond yields rose 139 basis points, or 1.39 percentage point, this quarter to 8.84 percent. Similar rates are 3.95 percent in China, 3.57 percent in South Korea and 2.77 percent in the U.S. The yield on India’s 7.16 percent notes due 2023 fell 12 basis points to 8.84 percent today.

Global Recovery

A pickup in the global economy will help boost the local services sector, which accounts for almost 60 percent of the nation’s GDP, helping India return to an average growth of more than 8.3 percent between 2014 and 2020, according to Dun & Bradstreet Information Services India Pvt.

“India’s economic growth has slowed markedly over the last two years due to structural and cyclical factors,” Arun Singh, an economist at Dun & Bradstreet in Mumbai, wrote in an Aug. 26 research report. “We expect stability in the external environment and recovery in global growth which will aid India’s growth journey during the coming years.”

Bond risk in India is rising as economists predict the economic slowdown will deepen in the coming quarters. Credit-default swaps insuring the bonds of State Bank of India against non-payment for five years have climbed 97 basis points since June to 372, according to data provider CMA.

While the RBI may eventually scale back the tightening steps, it is unlikely to do so until there’s more clarity on the Federal Reserve’s plans to reduce stimulus and before local financial markets stabilize, according to Standard Chartered.

“It’s unlikely the RBI will ease liquidity ahead of the Fed meeting on Sept. 18,” Nagaraj Kulkarni, a strategist at Standard Chartered in Singapore, said in a phone interview on Aug. 27. “We have enough indications that these tightening measures will be short-term. If these measures are prolonged, we could see them hurting the real economy.”

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