Fed rate cut could overvalue rupee

India may be forced to further restrict bank lending to keep inflation in check, reports Vyas Mohan.

The US Federal Reserve was widely expected to lower interest rates late on Wednesday (past midnight in India) to keep recession at bay. This would result in even stronger inflows of foreign funds into Indian markets, but that’s not necessarily good news.

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The money that would flow in after the US rate cut — overseas investors have already pumped in Rs 74,800 crore into our markets this year, double the record in 2005 — could severely overvalue the rupee, raising the spectre of a currency bubble as well as higher inflation.

The last time the Fed cut rates, in September, foreign investors pumped in Rs 16,132 crore ($3.95 billion) and the rupee appreciated 2.91 per cent against the dollar.

India may now be forced to further restrict bank lending to keep inflation in check. RBI has already done so four times this year, the last time on Tuesday. It raised banks’ cash reserve ratio — the percentage of their deposits to be kept in reserve with the RBI — to 7.5 per cent from 7 per cent, reducing the money available for loans.

“We expect another 1 per cent rise in the cash reserve ratio by the end of this fiscal,” said Shuchita Mehta, senior economist at Standard Chartered Bank. While a further restriction on bank lending would rein in inflation, it would also mean fewer corporate and domestic loans, thus slowing down growth.