RBI’s Forex Policy: Governor Das Sends Out Smoke Signals
Plumes of black smoke emerge from the chimney on the Sistine Chapel in Vatican City. (Photographer: Chris Warde-Jones/Bloomberg News)

RBI’s Forex Policy: Governor Das Sends Out Smoke Signals


The Reserve Bank of India is understandably ambiguous on what drives its thinking and policies on the foreign exchange market. For years the words ‘we only intervene to curb volatility’ play, seemingly on auto cue, the minute someone speaks of the rupee or of foreign exchange reserves.

No surprise then that the markets and analysts took note of comments from the RBI Governor Shakitkanta Das when he tweaked his message over the weekend.

At the Nani Palkhiwala Memorial Lecture on Saturday, Das said the following:

“Sustained accretion to foreign exchange reserves has improved reserve adequacy in terms of conventional metrics [emphasis added] such as (i) cover for imports (18.4 months) and (ii) reserves to short-term debt in terms of residual maturity (236%).”

Das added:

“Under uncertain global economic environment, EMEs typically remain at the receiving end. In order to mitigate global spillovers, they have no recourse but to build their own forex reserve buffers, even though at the cost of being included in currency manipulators list or monitoring list of the U.S. Treasury. I feel that this aspect needs greater understanding on both sides so that EMEs can actively use policy tools to overcome the capital flow related challenges.”

The smoke signals emanating from those comments may alter the debate on adequacy of reserves while also turning expectations on the currency.

Forex Reserves: How Much Is ‘Enough’?

The first of these signals is on the adequacy of forex reserves. Over the course of the past year, as foreign inflows into Indian equity surged, forex reserves climbed to record highs.

Forex reserves have risen to $542 billion as of Jan. 8 from $428 billion a year ago. Reserves are more than double the $275 billion they were when the 2013 taper tantrum hit. As Das pointed out, they comfortably meet traditional metrics of reserve adequacy such as import cover or the ratio of reserves to short-term debt.

This rise had prompted many to question whether the central bank would slow reserve accretion given that this build-up doesn’t exactly come free of cost. That chatter only grew after the U.S. Treasury department put India back on currency manipulator’s watch list as net purchases of foreign currency added up to 2.4% of GDP. The U.S. Treasury department uses a benchmark of 2% of GDP.

Das’ comment suggests that the central bank is going beyond conventional metrics for measuring adequacy. The undeniable possibility of volatility hitting global markets, together with perhaps geo-political concerns, may prompt the RBI to err on the side of caution while building these reserves.

Taking note of the comment, economists at Bank of America Securities reiterated their forecast pegging forex intervention in the current year at $93 billion and at $45 billion in FY22.

Needless to say, this marks a signal departure from the 15+year RBI stance of intervening in the forex market only to contain volatility. We have pointed out that Governor Das has achieved a silent rupee revolution by returning the RBI to adequacy of forex reserves after 8 years. This will ensure rupee stability putting large depreciations in global crises years of 2011, 2013 and 2018 behind us.
Indranil Sen Gupta, India Economist, BofA Securities

What Comes First: Reserves Or Liquidity?

If one takes that signal on forex reserves for what it is, then there are implications for domestic liquidity as well.

Again, over the last few months as domestic liquidity has been in large surplus, in large part because of the intervention in the foreign exchange markets, analysts have wondered whether the RBI would slow the reserve build-up to ensure it doesn’t add to the flush of money locally.

That logic may no longer hold, if it ever did.

Going by Das’ comments, the local liquidity conditions may only be the unavoidable byproduct of their interventions. By extension, even if they are uncomfortable with the surplus liquidity—and there is no clear indication that they are—they may not slow their forex purchases.

The RBI has a wide toolkit to deal with domestic liquidity implications of forex interventions, starting with market stabilisation scheme bonds, which were introduced for managing capital flows in 2004.

Rupee: Limited Room For Appreciation?

The final and perhaps inadvertent signal is on the direction of the rupee. The Indian currency was one of the worst performing in Asia in calendar year 2020. It has depreciated 2.7% over the past 12 months, matched only by the 2.95% fall in the Indonesian rupiah. All other Asian currencies have gained over the past year.

This in itself would be unexceptional if it hadn’t come in a year when the country received Rs 1.03 lakh crore in portfolio flows and recorded a rare current account surplus for at least two quarters. The reason the rupee underperformed was of course because the RBI intervened heavily.

Does Das’ signal that the reserve accretion will continue indicate limited upside to the rupee, except when the dollar weakens globally?

Over the medium term, the rupee maintains a depreciation bias, as would be expected given inflation differentials between developed economies and India. However, the currency has seen bouts of sustained appreciation in times of strong fund flows. If Das is signaling that central bank intervention and reserve accretion will continue in the foreseeable future, then any appreciation bias on the currency will be minimal, irrespective of how strong the inflows are.

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.

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