Rs Pays price for India’s low interest rate

India’s low-interest-rate regime in recent years has come at the cost of the rupee.

As the interest-rate difference between bonds in the United States (US) and India has steadily narrowed in recent years, the rupee has depreciated against the dollar at a steady pace.

In the past one year, the spread between the yields on government bonds – India 10-year and US 10-year – is down 70 basis points from 2.61 percentage points at the end of June last year to 1.91 percentage points on Tuesday.

In the same period, the rupee is down 3 per cent against the dollar from 83.73 to 85.97 on Tuesday.

The inverse relationship between the yields spread and the rupee-dollar exchange rate is not new. There is a high negative correlation between the India 10-year and US 10-year bond yield spread and rupee-dollar exchange rate.

In the past 25year, the rupee has tended to depreciate whenever the yield spread between India and US bonds has declined. In contrast, the Indian currency has appreciated against the dollar or has stayed stable during periods of a widening yields spread.

Experts attribute this negative correlation to the spread impact on capital inflows.

“A lower yield spread between the India and US bonds makes the Indian market less attractive to foreign portfolio investors, leading to lower FPI in our bond market and vice versa. Lower capital inflows in turn put pressure on the rupee, given that we consistently run a current-account deficit,” said a chief economist.

The recent dollar depreciation should have led to an appreciation in the rupee but the Indian currency has “depreciated in the past two months as yield spreads have narrowed, he said.

The decline in yield spreads is attributed to the RBI cutting rates faster than the US Federal Reserve. The Fed has kep its policy rate or Fed Fund steady, fearing higher inflation, while the RBI cut the repo rate by 100 basis points this calendar year. Others say, apart from this, the rupee has faced pressure from lower economic and corporate growth in India.

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