Friday, 15 April 2016

Indian rupee: choosing to remain the underperformer

 Foreign inflows picked up in a big way in the month of March when foreign portfolio investors bought over $4 billion in Indian equities, reversing outflows seen in the first two months of the calendar year

The monster rally in the US dollar, which started in mid-2014 and extended through most of 2015, has been steadily unwinding.
The Dollar Index, which measures the currency against a trade weighted basket, has dropped about 5.5% since December 2015. The drop in the dollar began after the US Federal Reserve indicated fewer interest rate hikes in 2016 than earlier expected. Since then, incoming data and the Fed’s concerns about the global economy have ensured that the dollar remains under pressure, although it traded higher in the US trading session on Wednesday.
The weakness in the dollar and the accompanying resurgence in risk-appetite have pushed up emerging market assets, including Asian currencies. Since the start of December, the Malaysian ringgit has gained 9%, the Indonesian rupiah has gained 5%, while the Thai baht and the Philippine peso have risen 2% each.
In contrast, the India’s rupee’s flat performance over this period makes it seem like an underperformer. This underperformance, though, is largely by choice and it may stay that way for most of this year. The reason is that the Reserve Bank of India (RBI) has chosen to mop up most of the incremental dollar flows that have come in, partly to avoid volatility in the rupee but also as a way to tackle the domestic liquidity shortage.
Foreign inflows picked up in a big way in the month of March when foreign portfolio investors bought over $4 billion in Indian equities, reversing outflows seen in the first two months of the calendar year. As the direction of flows reversed, RBI was quick to step in and buy dollars. This prevented an unnecessary spike in the currency but, more importantly, helped infuse rupee liquidity into the domestic markets, where cash was in short supply. Some in the market even argue that it would be the latter that was guiding RBI’s interventions rather than the former.
While the precise data for how much the central bank bought in March is still to come, a $14-billion increase in forex reserves between the week ended 26 February and 1 April suggests that RBI absorbed a sizeable amount of the inflows. Forex reserves now stand at a record $360 billion.
Since then, RBI has altered its liquidity stance dramatically and said that it will move away from maintaining a liquidity deficit for ensuring that liquidity is neutral. It will do this through a mix of forex operations and bond buying.
In fact, RBI governor Raghuram Rajan explained that the amount the central bank infuses through bond buys will be the residual amount required after accounting for interventions in the forex markets. “Given our target growth rate for durable liquidity, the amount that we infuse or take out will be the residual amount after accounting for interventions in the foreign exchange market,” said Rajan in an interaction with the business journalists on 5 April, when RBI’s monetary policy was released.
Rajan, however, added that RBI won’t do forex interventions only to manage liquidity. “That would have its own logic,” he added.
Luckily for RBI, even the standalone logic of forex markets allows it considerable space to absorb flows, and in turn, add liquidity to the domestic markets. As this column has consistently argued, the rupee remains overvalued on a real effective exchange rate (REER) basis. As such, holding the currency near current levels or allowing it to depreciate slowly by absorbing any excess flows would be logical. Put differently, RBI’s new liquidity framework provides an implicit guidance to the forex markets, which suggests that the rupee may see little or no appreciation this year, even if the dollar continues to weaken and other emerging market currencies rally on the back of strong inflows.
Some currency strategists have started to adjust their forecasts following RBI’s changed liquidity stance. In a note on Tuesday, Nizam Idris, head of foreign exchange and fixed income strategy at Macquarie Bank, pegged down the 3-month forecast for the rupee to 67 against the dollar from 66 earlier. The six-month forecast has been adjusted to 68.50 to a dollar from 67.50 earlier.
What remains uncertain is how RBI would tackle a period of outflows. Given the unstable world we live in, the probability of an event that sparks off another bout of risk aversion remains high. If that happens and flows reverse, RBI may find itself in a spot.
The significant build up in reserves means that the central bank has sufficient firepower to intervene, but if it steps in to sell dollars aggressively, it will suck out rupee liquidity. The heavier the intervention through dollar sales, the greater will be the need to infuse liquidity through bond market operations.
This could mean that RBI will intervene by selling dollars only if absolutely necessary. In contrast, it will buy dollars far more willingly. The implication—the rupee may retain a neutral to depreciating bias this year.
While some (most notably, foreign investors and overseas borrowers) may complain about that, in the grand scheme of things, it’s a positive development.

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