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By Suvashree Choudhury and Rajendra Jadhav
MUMBAI (Reuters) - The Reserve Bank of India (RBI) faces a tough choice in how it uses its monetary muscle. Does it protect a fragile rupee or does it ensure there's enough cash in the banking system so lending in the economy doesn't dry up?
The RBI needs to pick one battle at the expense of the other, while also acknowledging that either choice leaves apart of economy vulnerable.
If it defends the rupee, Asia's worst performing currency this year, it risks sucking massive amounts of rupees out of an economy already grappling with tightness in cash and unintended policy tightening.
The alternative is to let the rupee weaken past 70-per-dollar to record lows, eroding confidence and investment in an economy heading into general elections next year.
Economists suspect it may choose currency stability, regardless of how tight funding conditions get, a point the RBI reinforced on Wednesday when it raised rates and emphasised containing inflation as a priority.
"It is a tough balancing act for RBI to keep the rupee stable while maintaining a neutral liquidity stance," said A Prasanna, chief economist at ICICI Securities Primary Dealership.
"The fact that RBI raised the rate once again proves that they are serious about inflation targeting and comfortable with growth. That is why they might actually let the liquidity deficit build on, so that it is in line with its anti-inflation stance."
Such a decision, however, presents plenty of challenges for policymakers who are concerned about funding constraints in Asia's third largest economy.
The primarily inflation-targeting central bank has sold almost 5 percent of its foreign exchange reserves since April, trying to put a floor under the rupee. The currency is down 7 percent this year.
As it sold dollars for rupees, cash conditions domestically have tightened and yields have jumped.
Rates on 3-month deposits that banks place with each other have risen 100 basis points since April.
That's led to a rise in retail deposit rates, with the State Bank of India lifting some of its deposit rates by around 60 basis points on Monday.
At the same time, the RBI's bond purchases, part of its money market operations, have been modest and done little to help bank liquidity.
A second major factor impacting cash supplies is the Indian tendency to stockpile cash, rather than bank it, a practice that picks up in the second half of the year as people keep money aside to spend on the festive season.
Bankers estimate that a slow drain of rupees could result in the banking system having a daily deficit of about one trillion rupees, which is about 1 percent of bank deposits, by March 2019 from a daily surplus of 300-400 billion rupees in June.