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I'll spare you the "another BRIC in the wall" pun but it's clear that India's economic policy makers are being crushed between a rock and a hard place – forced to raise interest rates to protect the rupee from collapse at the expense of the country's economic activity.
The Indian rupee has been smashed in the past two months, declining 9.4 per cent against the U.S. dollar – among major developing nations' currencies, only the Brazilian real suffered more. Investment funds are fleeing the country in search of U.S. dollar exposure and, to make matters worse, hedge funds are shorting the currency.
In a surprise move Tuesday, the Reserve Bank of India (RBI) jacked interbank financing rates to help prop up the ailing rupee. Bank of America economist Indranil Sen Gupta doesn't think this will help. "Won't RBI rate hikes support the [rupee]? Unlikely, as the differential with the Fed rate was already at a historic 700 basis points."
Stubbornly high interest rates are already taking a toll on India's economy. Most recently, May industrial production was reported more than a full per cent below economist estimates at -1.6 per cent. "This supports our view that industrial growth cannot revive until lending rates come off," writes Mr. Gupta.
Policy makers will be anxiously awaiting some stabilization in the rupee so that interest rates can be cut to spur the economy through credit expansion. Even so, this will cause a further decline in the rupee that could ignite inflation for India's import-heavy economy.
The solutions are not obvious. The government already moved to restrict gold imports, in an effort to discourage currency holders fleeing the rupee and exchanging their money into bullion. The economy will be hard pressed to reach the consensus 5.7 per cent GDP growth for 2013.
Investors should stay clear until the dust settles and Indian interest rates decline significantly.
Editor's note: The article incorrectly referred to the Royal Bank of India and has been corrected. We regret the error.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights , and follow Scott on Twitter at @SBarlow_ROB .
Scott Barlow