By Ananth Narayan , Expert, Money Markets
Commentators have expressed surprise at the recent sharp move up in the US dollar against the Indian rupee, from 63.80 less than a month ago to briefly over 65.80 last week. While it did recover from there, the rupee underperformed major currencies during this period. What caused this recent move up in the dollar? We were just celebrating the rapid rise in RBI’s foreign exchange (FX) reserves, what changed in the past 3 weeks?
There is no shortage of commentary listing domestic and international reasons for the recent shift in sentiment.
However, to understand the past few weeks, we have to recognise that there was vulnerability building up over time. A pertinent question to ask is—who was selling the dollar against the rupee earlier this year?
Since the beginning of 2017, RBI has net purchased over $25 billion in the spot market, in addition to over $30 billion in the FX forward market. Where did this foreign currency (FCY) emanate from? India’s current account deficit is just about covered by our foreign direct investment (FDI) net inflows and foreign portfolio investor (FPI) investments in equity.
These are the closest to permanent sources of FCY into our country. So, if these cannot explain the $55 billion of FCY mopup by RBI this year, there must be a concomitant increase in our country’s unhedged exposures.
In other words, during 2017, our exporters have likely net sold forward FCY well in excess of importer forward covering, our borrowers have likely left FCY debt unhedged, and FPI in debt has come in unhedged. In addition, there is likely speculative long rupee position that has build up offshore. All this could account for a bulk of RBI’s FCY purchases this year.
These are only transient inflows. Eventually, buying of the dollar from importers and borrowers will catch up, particularly with our growing trade deficit. With unhedged exposures piling up to this extent, the market was like a compressed spring, awaiting an excuse for a correction.
So why have unhedged FCY exposures built up over the year? First, we are susceptible to a herd mentality. Particularly since the BJP’s electoral win in UP in February, and post the implementation of GST in July, the consensus feel-good sentiment about Indian assets was strong.
Second, the cost of buying forward dollar—the USD-INR forward premia—was seen as high, particularly given the one-way movement down in USD-INR spot this year till recently. For a good part of the year, the 12-month USD-INR forward premia was close to Rs 3, before dropping to about Rs 2.75 now.
Relatively high rupee yields and USD-INR forward premia are on account of two issues. First, with our inflation-centric monetary policy framework, domestic real interest rates are attractive. This is a reflection of the impossible trinity—it is a struggle to have an independent monetary policy alongside relatively free capital flows, and simultaneously avoid vulnerabilities on the currency front. Monetary policy has to contend with the impact on the external sector.
Second, RBI has been buying a big chunk of its dollars in the forward market in order to avoid the rupee liquidity infusion that a spot dollar purchase entails. This, in turn, kept forward premia supported, and possibly incentivised further build-up in unhedged exposures. Given interest rate parity is imperfect in India, if RBI chooses to stay away from the forward market, forward premia can come down to levels that allow for more balanced hedging flows. Perhaps liquidity implications can be handled entirely through money market operations.
So where do we go from here? The good news is that RBI has the offsetting dollar to all the unhedged positions built up. It can stabilise markets whenever it chooses to, at least in the short run. Questions remain, of course. For one, the RBI and MOF (and the country) could legitimately do with a gently weaker rupee, as one way of responding to a widening current account deficit, and perhaps to foster domestic industry.
Second, the RBI might want to ensure that there is a shakedown in the size of the unhedged positions, so that this cycle does not repeat. Some FX volatility might just be the medicine needed to induce FX hedging. On the flip side, we have to avoid spiraling panic in our FX markets, which could impact other asset markets. That would hurt our real economy rather than help it.
For now, is a Rs 2 range in USD-INR over 20 days enough to balance these considerations? It does seem so, but that is the call for RBI to make.