From Forex To Bonds, RBI Faces A Whack-A-Mole ChallengeBloombergQuintOpinion
The Indian currency, bond and money markets have each seen their own share of the drama over the past year as the Reserve Bank of India battled exceptional circumstances amid the Covid crisis.
In doing so, the Indian central bank has stepped up intervention across markets to maintain what Governor Shaktikanta Das called “congenial” financial conditions. But interventions in one market segment have, inevitably, led to anomalies in others.
Call it the RBI’s whack-a-mole problem.
The Rupee Forward Premia Mole
The most recent market to see this play out has been the forex market.
Over April and May, concerns cropped up over a rise in the dollar/rupee forward premia. The 12-month forward premia surged to over 5% in early May but since has fallen to below 4.5%. Simply put, the forward premia is the difference between the spot dollar/rupee rate and the forward rate, say one-month or three-months or one-year down the line.
What led to the rise in forward premia is an episodic narrative with one underlying factor — the RBI has been intervening via the rupee forwards market more than it ever has.
Data available as of March shows that the RBI had an outstanding forward dollar position of nearly $73 billion. This, according to Vivek Kumar, economist at QuantEco Research, is the highest it has ever been.
While the RBI often intervenes in the foreign exchange markets, both to prevent undue appreciation and depreciation, its intervention is predominantly routed through the spot markets. Here, it either buys dollars, in turn releasing rupee liquidity or sells dollar, absorbing rupee liquidity.
Over the past twelve months, though, the rush of foreign inflows has been strong with India receiving $36.2 billion in FPI flows, the highest since 2016-17. Couple this with a record high FDI flows of $81.7 billion.
This forced the RBI to intervene not only via the spot markets but also via forwards as it tried to prevent a sudden appreciation in the Indian rupee, which could hurt India’s export prospects while also leaving it vulnerable to sharp corrections later if flows were to reverse.
There are a number of theories doing the rounds on why the RBI started intervening more in forwards than in the spot market.
One theory says that the central bank did not want its balance sheet to expand too much as that would have required them to set aside more reserves, which would have led to a lower surplus transfer to the government. Buying forex exchange in the spot market immediately increases the size of the RBI’s balance sheet, which consists of domestic assets, like bonds, and foreign assets, i.e forex reserves.
The central bank, however, maintains that balance sheet considerations don’t drive its forex management approach.
Another explanation is that given the already large surplus of liquidity in the domestic markets, the RBI may not have been keen to add to it via heavy spot forex purchases. This liquidity would have come right back to the RBI via the reverse repo window and, at some point, the central bank may have started to run down the pool of securities it offers to those who park funds at the reverse repo window. Banks were parking between Rs 6-7 lakh crore with the RBI in those days and government cash balances were high as well.
A third possible explanation is that tools used in the past to mop up excess liquidity generated by forex flows, such as market stabilization scheme or MSS bonds, were not seen as a good idea in the current context since they would have added to the already heavy supply of government paper in the market. In such a scenario, the RBI used the tools it could.
This is where we come back to the whack-a-mole analogy.
The reason this situation arose is because the RBI was not willing to let the dollar/rupee find its own level. For good reason, yes. But as the RBI intervened heavily to keep the spot rupee rate stable, it eventually ended up distorting the forward premia.
To be sure, apart from the RBI’s intervention strategy, a few other factors may have played a role in the volatility in the forwards market.
Large inflows linked to the Powergrid InvIT caused some of it. A change in the RBI’s large exposure framework, which essentially limited the dollars that foreign banks could park with their parent entities, has also played a role, forex traders say.
The forward premia has now settled at more reasonable levels.
Madhavi Arora, economist at Emkay Global, said that the RBI has started to unwind some of its forward positions and take delivery of forwards coming due. It has also been seen to be taking early delivery. This has helped bring down the forward premia, which according to Arora, had risen through the combination of factors discussed above.
She added that as the forward premia rose, opportunistically it may have made more sense for the RBI to absorb liquidity at 3.35% via its reverse repo window rather than pay a higher 4.5% or so in the forward market.
Besides foreign inflows have moderated.
Even as the forward premia has come down, it is still higher than historical averages, said Kumar. He added that given the narrowing inflation differential between the U.S. and India, the premia may have been expected to move lower but it hasn’t.
In the end, a higher premia makes it more expensive for corporates to hedging their forex exposure and disincentivises them, Kumar explained. That may lead to its own risks down the line. Arora shared that view, cautioning that uncomfortably high premia could still emerge at times when sudden large inflows are seen.
The Many Bond Market Moles
The juggling act the RBI is being forced into in the forex market has a parallel in the bond and money markets.
At first, when the RBI flooded the system with liquidity, much of it rushed towards short-term commercial paper borrowings. The result was that for a period of time, the government and even some high-rated corporates were borrowing at rates below the RBI’s reverse repo rate, in some ways rendering monetary policy ineffective.
The RBI tackled that by restarting variable rate reverse repo operations.
Around February, markets started to push up the 10-year benchmark yield, both on account of high government borrowings of Rs 12 lakh crore for the current year and because of expected policy normalisation during the course of the year.
The RBI thought it was too early for benchmark rates to rise and so it started to buy these securities via open market operations, secondary markets and, most recently, its G-SAP program. As Bloomberg reported, the RBI now holds more than 50% of the benchmark security.
While the RBI focused on the 10-year, other segments of the market started to see a rise in the rates. First, it was the 5-year bond yield, then yields on longer-dated bonds and most recently state bonds. The RBI has had to step in to cool off each of these markets from time to time.
Moral of the story — no action is without a reaction.
The RBI’s juggling act is unlikely to end soon if it believes that keeping both the rupee and benchmark yields in check is the way to go. Maintaining monetary policy independence while allowing a steady flow of foreign capital and keeping a stable currency is called ‘The Impossible Trinity’ for a reason.
Ira Dugal is Executive Editor at BloombergQuint.
The author would like to thank Vivek Kumar, economist at QuantEco Research and Madhavi Arora, economist at Emkay Global for their inputs.