The RBI’s move to curb the Indian rupee volatility will actually have just the opposite result.

Announcing its steps, the central bank said cheap liquidity in the domestic money markets is one of the causes for the rupee  hitting record lows against the dollar.

The RBI believes banks are borrowing funds from it at 7.25 percent (called repo rate) from the liquidity adjustment facility (LAF), which is a daily auction of government bonds, and using that borrowed money to  buy the dollar, which also means they are selling the rupee.

The RBI holds daily LAF auctions to help banks meet any constrain in their liquidity. The RBI has now limited the amount banks can borrow from the LAF window to 1 percent of their net demand and time liabilities (NDTL) or deposits.  This means banks can as of now borrow up to Rs 75,000 crore.

It has also increased the marginal standing facility rate by 200 basis points. As per the RBI norm, the rate at the MSF, an emergency funding facility window which banks access when they fail to get funds from the LAF, was 8.25 percent, 100 basis points above the repo rate. With the increase in this rate, banks can access these funds at 300 bps above the repo rate, i.e at 10.25 percent.

The RBI is also conducting an open market operation sale auction on 18 July to suck out liquidity of up to Rs 12,000 crore from the system.

What the RBI wants is to make cash costlier in the system. It wants to make it unviable for speculators to borrow rupee funds from the RBI and buy the dollar to earn a quick profit.

Banks are at present borrowing over Rs 90,000 crore from the LAF window. With the RBI limiting this to Rs 75,000 crore, borrowers will have to bid for funds from the market. The RBI’s liquidity tightening will push up overnight money market rates to over 10 percent  levels. Banks also borrow funds from the call money market and Collataralized Borrowing and Lending Obligation (CBLO). Unlike call money, CBLO is a fully secured or collataralised (banks use government securities as collaterals to borrow) instrument.

The RBI’s actions will lead to higher short-term rates, higher long-term rates, more FII debt sales and more weakness in the rupee. Short-term rates will rise as cash becomes costlier while OMO bond sales will raise long-term rates. Rising interest rates will prompt FIIs to sell more bonds and this will lead to the rupee falling and the cycle will continue.

The RBI could have rejected bids for repo in the LAF auctions rather than taking such volatility inducing measures. Rejecting bids for funds in the LAF will make borrowers go to the market for funds leading to overnight money market rates trending higher on the back of higher demand for funds. However, the RBI has chosen to take a more complicated route to prevent the rupee volatility and this will most likely backfire on the central bank.