Why India's rate hike decision wasn't really a wrong move

Contrary to investors' arguments.

According to Morgan Stanley, it has heard a number of investors and top managements in the corporate sector arguing that the RBI has made an inappropriate move by lifting interest rates in response to currency instability.

However, Morgan Stanley says, "We think lifting short-term real rates was the most appropriate response to recent external developments."

Here's more from MS:

Low real rates since the credit crisis only supported repression, decline in saving and higher gold imports: The RBI has been managing interest rates at levels lower than warranted all through this cycle.

Though private investment did not respond to low real rates, the RBI's accommodative monetary policy gave the government continued support to run a high fiscal deficit – one of the key factors behind high inflation.

While high government deficits meant a decline in public saving, negative real rates for savers caused a further decline in household saving. As saving declined faster than investment, the current account deficit kept widening.

Fixing real rates is inevitable: In the context of the quick and sharp rise in US 10-year real yields, we believe India had no choice but to lift its own real rates to address the funding stress.

More importantly, in the context of the government's inability to quickly augment public saving by aggressive pro-cyclical fiscal tightening, hiking real rates was the only credible way to demonstrate a commitment to reduce the saving-investment gap.

Bottom line: the key to the outlook for risk assets will be the spread of real GDP vs. real rates: Even as we expect saving to rise and investment to slow over the next 12 months, the current account will still be in deficit (i.e., India will still be short of saving).

Hence, trends in US real rates/the US Dollar will remain the key driver of domestic real rates. We thus believe the key will be to lift real GDP growth with policy reforms and change in expectation of the returns on investment for entrepreneurs by systematically addressing the issues related to the business environment.