RBI Changes Tack As Re Crosses Comfort Zone

MUMBAI: The deluge of forex inflows, particularly in the last three months, has emerged as a major challenge for RBI. The central bank had to engage in a tightrope walk to maintain exchange rates at desired levels and to manage liquidity generated through inflows.

India has attracted inflows worth over $35 billion from all sources, including portfolio inflow, FDI and external commercial borrowings since early July this year. Of this, RBI has mopped up over $30 billion. These inflows need to be converted into rupee funds to use them in local markets. But it could also generate excess rupee funds in the system and put inflationary pressure on the economy. The central bank, which is also the country’s monetary authority, then intervenes in the market and mops up the excess inflows with the aim of maintaining the level of the currency at the desirable levels (too much inflows increase dollar supplies and hence weakens the currency, which, in turn, upsets the exporters’ sentiments).

Of late given the strong inflows, despite mopping up huge inflows, the dollar is still weakening against the rupee. RBI has a choice of instruments to intervene in the currency markets to achieve its objectives.

The most popular method has been through the sale of bonds and mop-up of excess funds. But with RBI’s stock of bonds almost exhausted, the government has floated special bonds under its market stabilisation scheme (MSS) that will help RBI manage liquidity. In a scenario marked by strong inflows, the central bank hikes the reserve requirements so that banks keep aside a higher amount of deposits they mobilise as reserves with the central bank and in the process restricts the money supply. The central bank also hikes benchmark policy rates (repo rates) in an attempt to tighten money supply.

But, of late, there seems to have been a change in the central bank’s intervention strategy, considering that each instrument has its own limitations. RBI has been treading a path rarely used by it. Treasury managers say that the central bank has been, of late, intervening in the forward market and managing the rupee. It is reported to have bought dollars in the spot market and sold it at a future date. This helps RBI reduce supply of rupee funds without hurting the value of the rupee.

According to forex consultant AV Rajwade, intervening through the forward market does not add to money supply immediately. As far as influencing exchange rates in the spot market, when banks sell dollars in the forward market, they make the initial purchase in the spot market and then enter into a swap deal.

Theoretically speaking, this kind of an activity should help in influencing rates in the spot market. In the current context, it is felt that the other alternative before the central bank was to have either intervened to a greater extent in the spot market itself or to have gone in for a hike in cash reserve ratio, instead of taking the MSS route, given the huge difference in costs involved.

From the liquidity perspective, such an intervention helps control the funds floating in the banking system. According to Standard Chartered Bank MD and head, corporate sales, global markets, Hemant Mishr: “The central bank could progressively use other direct or indirect tools to contain inflows-related over-valuation of the rupee. As indicated by the finance minister P Chidambaram, the rupee has crossed the comfort zone. Any credible action by RBI would be taken seriously by market players.”

Treasury managers say that RBI’s intervention in the forward market is reflected in the contingent liabilities and, hence, does not immediately reflect in the books of RBI. However, it needs to be noted that the intervention of RBI in the forward market is capped. The central bank has a major advantage in intervening through the forward market because it has the option of rolling over the forward contracts.

In terms of options, experts feel that the central bank could examine imposing capital controls, where the quality of flows could be an important criteria. Dual exchange rates or the Tobin tax are the other options.

The central bank should have policies in place by which players bringing in funds into the country should not be allowed to take funds out of the country easily, explained a senior treasury official.