EM Rout Forces India's RBI Into Conflicting Market Actions

(Bloomberg) -- A global squeeze on emerging market assets has forced the Reserve Bank of India to take actions that sometime appear at conflict with each other.

To help cool rising bond yields, the central bank said late last week that it will buy bonds for the first time in 18 months, infusing cash into financial markets. But that counters moves to prop up a sliding currency -- by selling dollars from reserves and buying up rupees, effectively draining liquidity.

The weaker currency, by driving up import costs, is adding to inflation risks at a time when oil prices are already climbing. That’s leading policy makers to warn of higher interest rates sooner rather than later -- a hawkish bias that is acting as an upward pressure on bond yields, which of course, the RBI is seeking to contain.

The RBI isn’t alone in this conundrum. Emerging markets from Argentina to Turkey have all faced similar tough choices as a stronger dollar and rising U.S. Treasury yields push investors to dump higher yielding assets.

“Developments in the bond and foreign exchange markets have complicated the monetary policy setting, raising questions about the RBI’s primary objective,” said Priyanka Kishore, lead Asia economist at Oxford Economics Ltd. in Singapore.

The RBI’s main goal is to keep inflation around the 4 percent midpoint of its target band. While inflation has eased in recent months, policy makers are wary of rising risks and have started to flag a possible interest rate hike this year. Kishore said there’s still a fair chance of an increase in June.

The RBI’s juggling act has come into sharp focus with the rupee’s 5.2 percent slump against the dollar this year, the most in Asia. Foreigners have been selling Indian bonds, putting downward pressure on the currency.

To counter that, the central bank has tapped foreign reserves to support the rupee. But that takes liquidity out of the market, and along with rising demand for currency notes among locals, it’s led to cash in the banking system dwindling.

To ease that crunch, the central bank is now buying bonds to inject liquidity back into the market.

Back in 2016, the infusion of cash through debt purchases was hailed as the biggest shield to the market. This time around, it has investors questioning the timing of the move when liquidity is still surplus.

“It is very difficult to figure out what the monetary policy is targeting,” Jahangir Aziz, head of emerging market economics at JPMorgan Chase and Co., said in an interview to BloombergQuint last week. “Is it targeting the inflation rate, is it targeting the 10-year rate or is it targeting financial stability?”

Part of the dilemma stems from the fact that the RBI acts as the government’s debt manager and, as a consequence, has to balance competing needs: keep borrowing costs low to ensure that a 5.6 trillion-rupee ($83 billion) debt program proceeds smoothly, while also curbing prices as an inflation-targeting central bank. It also has to ensure the good health of India’s banking industry, especially state-run lenders who are the biggest investors in government debt.

Bond Blues

Among the RBI’s more immediate headaches has been the need to curb a sharp rise in bond yields and restore the appetite for debt, which is proving harder given the sell-off in emerging-market assets recently.

The open-market bond purchases come after the shortest debt on sale was rescued by underwriters for a third straight auction last Friday.

Read Bloomberg Economics’s Insight on Why RBI Will Need to Buy Bonds

Yields on the 10-year bond increased 37 basis points in April even after authorities announced a spate of measures to help bolster the market, such as easing debt investment rules for foreign investors, lowering the borrowing program and allowing banks to spread out their bond losses over four quarters.

The RBI has more leeway to offset exchange-rate pressures through other means -- intervention, capital account opening, gold-import restrictions, and will probably use other liquidity tools to guide the policy rate to the upper end of the corridor before it even considers a rate increase, Citigroup Inc. economists said in a note.

The RBI’s latest salvo -- its surprise $1.5 billion bond purchase plan -- gave bonds some respite, and with the government poised to extend the use of open market purchases, that may help to keep a check on yields.

Nomura Holdings Inc. estimates the RBI may purchase another 800 billion rupees to 1 trillion rupees of bonds in the year that ends in March 2019.

“That said, not all is clear and this is not a market to chase bonds, in our view,” Nomura analysts Vivek Rajpal and Prashant Pande wrote in a note. “We believe uncertainty around rate hikes and oil prices is still weighing on bond markets, and as such we maintain our neutral stance.”

To contact the reporters on this story: Anirban Nag in Mumbai at anag8@bloomberg.net, Subhadip Sircar in Mumbai at ssircar3@bloomberg.net.

To contact the editors responsible for this story: Tan Hwee Ann at hatan@bloomberg.net, Nasreen Seria, Karthikeyan Sundaram

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