Recent RBI regulations to curb speculative activity in FX markets have fanned fears that the central bank could soon resort to interest rate defence of the rupee, just like 2013.  Market participants are also interpreting a recent remark from Governor Sanjay Malhotra that monetary policy cannot be completely delinked from financial stability objectives (even as he emphasised policy preference to use macro prudential tools for the same) as a signal that taper tantrum period like monetary tightening could be on the cards.

RBI has already dipped into the macroprudential toolkit used in 2013 and experimented with new tools to stabilise the rupee.  These include curbs on cancellation and rebooking of forward contracts, opening of a separate window for Oil Marketing Companies to fund their inelastic dollar demand and charging a Foreign Exchange Risk Reserve, or FERR, levy on hedging demand from importers to make that costlier.  A sharp fall in foreign exchange reserves, which were earlier buoyed by the subsidised FCNR(B) flows, has added to speculation about interest rate defence also. 

RBI has extinguished half the net flows under the FCNR(B)+ECB+OFCB scheme in less than two months; is it running out of ammunition fast?

To look at the data, RBI’s Foreign Currency Assets were $515 billion in early June, before the central bank rolled out the incentives for FCNR(B), ECB and OFCB flows.  The assets surged to $648 billion by the start of September, mainly buoyed by net flows of $127 billion under the three schemes.  But more updated data would show Foreign Currency Assets fell to around $590 billion. 

As the dollar has strengthened in recent weeks, there will be some drag to Foreign Currency Assets  from valuation-linked losses.  But it appears that half of the net inflows under the three schemes (i.e. $60 billion-65 billion) have already been spent by RBI to defend rupee.  That is a sizeable intervention in a span of less than two months.  A mitigating factor is that RBI has used the flows to aggressively unwind its forward liabilities, particularly those that were maturing in the next one year.  These dollar sell/buy swaps should be nearly half the total amount spent (i.e. in the vicinity of $30 billion). That still implies spot FX intervention totalled $30 billion-35 billion, which comfortably exceeds the demand for dollars from BoP deficit in this period.   

Despite RBI effectively signalling that 97 level is a line in the sand for dollar-rupee, at least temporarily, there is no need for the central bank to consider interest rate defence again.  Such talk looks premature when dollar-rupee is nearly flat since early June.  Also, since the start of West Asia conflict from end of February, rupee has weakened about 4% only.  In both periods, rupee has outperformed the euro, which can be taken as the best proxy for wider dollar moves. 

This stability has come at the cost of a sharp drawdown in FX reserves, but it would be more puzzling if RBI didn’t put the assets to use. The central bank still has substantial ammunition, unlike in 2013 when import cover of FX reserves declined to merely six months, nearly.  It can be argued that if current FX reserves are netted for the $200 billion of liabilities in the forward book, the import cover falls to less than seven months again.  But it is more appropriate to adjust the forward liabilities that are due in short term (i.e. next one year) rather than repayments that are due in medium and long term.  And forward liabilities due over next year are quite modest (at $24 billion).  The import cover netting out for these is well above nine months, which is very comfortable. 

Cost-benefit analysis doesn’t favour MSF hike

Most important, the entire purpose of RBI considering an outsized MSF hike is questionable as forward implied yields are already elevated and that is the key objective of interest rate defence. 

Note that dollar 3-month SOFR (4-4.1%) plus rupee onshore forward implied yield of same tenor (6 - 7%) (to calculate synthetic rupee onshore interest rate implied in forward FX market) is already 10.5%, closely matching the peak effective policy rate in 2013 after MSF hike (10.25%).  Compare that with the 3-month OIS rate (that encapsulates policy rate expectations for the same period), which is much lower at sub-6% currently.  Even if we consider 1-year tenors instead of 3-month benchmarks, FX market implied interest rates are very high – ranging between 8.5% and 9% recently instead of current policy rate of 5.5%. 

Elevated forward premiums in turn reflect RBI’s dollar sell/buy intervention activity and aggressive spot market interventions that have pushed up dollar liquidity in the banking system.  In 2013, RBI didn’t have the ammunition to deploy FX reserves in a big way and resorted to interest rate defence first. The resulting high bond yields in government and corporate bond markets then created incentives for banks to mobilise FCNR deposits aggressively.  However, with incentives to attract capital flows rolled out first this time (and low onshore interest rates didn’t curb the bounty), strong FX reserve buffer has allowed the central bank to intervene aggressively.  That has pushed up the forward premiums without RBI tightening monetary policy aggressively.  Whether higher forward premia reflect RBI’s intent fully or is it a collateral damage from the central bank’s preference of tools for liquidity management (high bar for CRR hike) is unclear though. 

Aggressive liquidity tightening not required; RBI could seriously consider 50bps repo rate hike in December

RBI doesn’t need to consider aggressive liquidity tightening measures also. Headline liquidity surplus has come down sharply and overnight money market rates are also trading closer to the upper bound of LAF corridor i.e. MSF rate.  Partly, this is because of temporary factors, including buildup of high government cash surplus that has depleted banking system liquidity.  But high yields in FX market have likely diverted bank lending towards it.  As a result, funding costs in TREPS/CROMS markets have gone up. 

The core liquidity surplus or the underlying level of liquidity balance in banking system remains very high.  But that should normalise by the end of fiscal year as BoP outlook remains adverse.  As overnight rates have drifted higher, RBI may have more leeway to look through the elevated core liquidity surplus in the current quarter. 

In case rupee remains under pressure in run up to the next meeting (without the crutch of the central bank’s support), RBI could seriously consider front-loading policy normalisation, however.  A 50 bps repo rate hike instead of staggered 25 bps rate hikes in each of next two meetings could be more suitable tactically.  It will also be consistent with RBI’s whatever it takes approach to manage rupee volatility recently.  Repo rate of 6% would lower chance real policy rates turn negative as inflation picks up and avoids poor optics.