U.S. Treasury Versus RBI: An Intervention To End All RBI Interventions

BloombergQuintOpinion

The Reserve Bank of India recently attracted international attention when a U.S. Treasury report highlighted India’s growing currency intervention over the last year. It’s a topic that — unlike most — is bound to stick with Donald Trump who, in the past, has gone on the offensive against China over similar claims. India’s net purchase of forex reserves to GDP at 1.8 percent in June 2017 was just shy of the 2 percent benchmark. This meant it came “very close” to being put on the list of countries to be monitored for unfair currency practices in the latest report. These reports are compiled on a semi-annual basis, which affords the RBI some time to escape the gaze of U.S. authorities next time around. However, for the RBI, the cost of avoiding the list might be too high, leaving it in a severely constrained position. Also critical to note is that the intervention figures for India in the report provide a decisive interpretation/definition of ‘forex intervention’ - one that has been absent in Indian (if not global) policy debates.

U.S. Treasury’s Monitoring List Of Currency Manipulators

Provisions of the Trade and Facilitation and Trade Enforcement Act of 2015 require that the U.S. Treasury undertake an enhanced analysis of exchange rate policies of each of its major trading partners. To determine whether an economy may be pursuing unfair foreign exchange policies, it lays down three clear, quantitative benchmarks:

  • An economy that has a significant trade surplus with the U.S. i.e. if its bilateral trade surplus is larger than $20 billion.
  • An economy that has a material current account surplus i.e. if its surplus is larger than 3 percent of that economy’s GDP.
  • An economy that has engaged in persistent one-sided intervention in the foreign exchange market i.e. repeated net purchase of foreign currency greater than 2 percent of the GDP over that year.

If a country meets two out of the three criteria, it is put on the monitoring list. Once on the monitoring list, an economy remains there for at least two consecutive reports.

As per the latest report, India came “very close” to being included in the list. It meets the first criteria given its trade surplus of $23 billion (Oct. 2017 report) with the U.S. and came close to meeting the second criteria with a net foreign exchange intervention of 1.8 percent of the GDP. Since India doesn’t publish a ‘net foreign exchange intervention’ series, it's important to understand how the U.S. is measuring India's intervention.

A New Way To Understand RBI’s Intervention

Part of the reason why central banks don’t publish foreign exchange intervention data is that there is no universally agreed definition of it, even at the International Monetary Fund. Consequently, there is a lack of consensus over the components that define its scope. With self-interest at stake, and under the mandate of the 2015 Act, the U.S. Treasury report provides a decisive interpretation of RBI’s intervention — one that includes its forwards and other derivative transactions.

Most conversations around forex intervention by the RBI — and other central banks — revolve solely around the forex reserve numbers, largely ignoring off-balance sheet items like derivatives.

Particularly for India, ignoring these derivative items would yield only a fraction of the true, intended intervention by the central bank. And this has been especially true over the past year.

The intervention figures in the U.S. Treasury report come at the right time to dispel this collective obstinacy and cement the (right) idea that derivative transactions by the RBI should be spoken in the same breath as forex reserves. The reported figure for intervention by India stands at $42 billion as on quarter ending June 2017, for the trailing four quarters. Compare this with the addition of $26 billion to forex reserves during the same period. To reverse-engineer the intervention of $42 billion, one needs to simply add the net purchase/sale of U.S. dollars by the RBI and the change in the forward position during those four quarters. RBI releases both datasets on a monthly basis. The net purchase of U.S. dollars for four quarters trailing June 2017 was $17.4 billion, while the net forward position of RBI went from -$7.4 billion (short) in June 2016 to +$17 billion (long) at the end of June 2017 — an increase of $24.5 billion. This sums up to $41.9 billion... ~$42 billion dollars.

Using the same reverse-engineering process, one can arrive at the intervention number reported for the two quarters trailing June 2017. In fact, we were able to replicate the intervention figure in the April 2017 report as well (as depicted in the chart below). The figure reported in the October 2016 report – the first such report to feature intervention figures – however, does not match up. This could be due to the omission of the forward intervention component from the calculation – as the net purchase of U.S. Dollar yields the same number as the intervention.

A simple hypothetical might help to get an intuitive sense of how forward interventions by the RBI work in India. Let’s say Warren Buffett decides to enter the Indian equity markets with $1 billion. RBI doesn’t want this hot money to increase rupee volatility and decides to intervene. It could directly buy $1 billion and increase its reserves. Or it could enter a sell/buy swap wherein it buys these dollars from Buffett and gives equivalent rupees in the first stage. Then, on the same day, it sells the dollars spot to let’s say, Axis Bank, in exchange for rupees — thus reversing its initial rupee injection — with the promise of buying the dollars in the future at a pre-determined rate i.e. a forward contract.

Why would RBI indulge in this complex process? Many reasons. Firstly, since the rupee liquidity is reversed in a sell/buy swap, there is no need for sterilisation.

Consider India’s case in recent times where the rupee liquidity in the system has been high and there is limited availability of Government bonds for sterilisation.

U.S. Treasury Versus RBI: An Intervention To End All RBI Interventions

Secondly, and more importantly, these swaps appear as off-balance sheet items under contingent claims, thereby leaving the actual forex reserve number unchanged. Thirdly, it allows RBI to absorb high levels of rupee pressure and release it in small quantities in future.

Imagine the swap transaction by RBI as putting a dam on a river of incoming dollars.

When the water level is high i.e. pressure on the rupee to appreciate grows, then the swap transaction allows the RBI to stem the pressure and release it in small quantities on future dates. The longer the maturity of the forward contracts, the greater the flexibility in easing pressure in the future.

All benefits aside, a worrying point now for the RBI would be the accumulation of significantly large forward positions in the months of July and August 2017. As per the latest data, the forward position went from $17 billion (long) to $33 billion (long), an increase of $16 billion in just two months. The period of assessment for the next report will be January-December 2017. So far, till August 2017, RBI has conducted intervention worth $51.6 billion.

Even if the RBI doesn’t intervene in the remaining four months in 2017, India’s GDP will have to grow by more than 10 percent in order for $51.6 billion to stay below the 2 percent GDP criteria.

The other option is to sell reserves or take short positions against the dollar. But if the capital inflows keep up their pace – as they have for most of this year – the impact of selling reserves or taking short positions would further increase the pressure on Rupee to appreciate.

Conclusion

For a long time now, RBI has indulged in off-balance sheet activities to dress up its on-balance sheet items, namely forex reserves. With the U.S. recognising forward contracts, swaps, and other derivative instruments as interventions, all stakeholders must give equal attention to off-balance sheet items like derivatives. The looming threat of inclusion in the monitoring list in the next Treasury report is bound to put RBI into a corner.

With four months left in the assessment period, RBI has already exceeded the 2 percent of GDP benchmark for foreign exchange intervention criterion.

To counter the effect of persistent capital inflows this year, RBI has intervened repeatedly to prevent the Rupee from appreciating. But further intervention going forward will come at the price of being included in the U.S. monitoring list, an outcome every economy would prefer to avoid at all costs given the mercurial president at the helm.

Mohit Desai is a researcher at the National Institute of Public Finance and Policy.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.