Unlike monetary policy, which is conducted under the explicit mandate of inflation targeting, foreign exchange management is left to the discretion of the Reserve Bank of India (RBI). For many years now, RBI has maintained that it does not target any value of the Rupee, and only steps in at times to control some unstated measure of currency volatility. However, the sheer magnitude and nature of RBI intervention leaves it as a substantial determinant of currency market rates, irrespective of its stated policy or intent. And the central bank’s role in the currency market has been manifesting in a major way particularly over the past few months. The core of RBI’s intervention policy through FY21 was excellent. It acted as a volatility heat sink amidst massive foreign exchange inflows. It prevented excessive rupee overvaluation that could have impeded India’s domestic output, employment, and the prospects of the Atmanirbhar Bharat tilt. However, aspects of the impossible trinity—the interplay between monetary policy, capital flows, and currency markets—need to be better debated. Interest rate differentials (based on the repo rate set by the RBI) impact our currency markets and trade competitiveness. Likewise, excessive RBI forward market intervention can entail huge hidden costs, besides fostering speculative flows. Finally, while calls on RBI to use its substantial forex reserves to fund India’s domestic investment make little sense, we could consider setting aside funds towards securing strategic international resources. In all, perhaps a more transparent and considered articulation of RBI’s thinking around foreign exchange management can instill better all-round clarity, credibility, and confidence, without compromising on any of RBI’s operational flexibility.
Currency flows in FY21
India received record durable inflows during FY21. Amidst a sharp drop in consumption and imports as a result of the pandemic, India’s FY21 current account balance was a surplus of about $27 billion till February 2021. During the same period, we received net Foreign Direct Investments (FDI) of $41 billion, and equity Foreign Portfolio Investments (FPI) of $36 billion. Despite the substantial $104 billion of durable foreign currency inflows, the dollar barely weakened by 2% against the rupee in nominal terms—from 75.30 in March 2020 to 73.90 in February 2021. This was even as the trade weighted global US Dollar Index (DXY)—a measure of the dollar’s strength against other currencies—dropped by 8.2% from 99.0 to 90.9. This relative stability in the dollar-rupee equation was because the RBI stepped in to purchase an estimated $74 billion in the spot markets and another $79 billion in forward markets. Given the sheer scale of intervention and influence, RBI’s oft-repeated statement—that it does not target any level and that it intervenes only to reduce some unstated measure of volatility—underplays its considerable market impact. A legislated inflation targeting mandate sets the guardrails for the conduct of the Monetary Policy Committee (MPC). In contrast, there is no public framework that guides RBI’s foreign currency operations. We can only guess how the RBI might decide on its foreign exchange operations. For one, the RBI likely would have considered whether the massive durable foreign currency inflows of FY21 was a one-off. Prior to FY21, with some fluctuations, India saw an average annual durable outflow of just $1 billion. The peak inflow before FY21 was $28.9 billion in FY17. To that extent, this appears to be a covid-19 driven one-off, amidst a sharp drop in consumption and imports and a surfeit of global liquidity.
If the RBI had allowed the currency to “find its own level" through FY21, the dollar could have spiralled to perhaps 68 or lower against the rupee. Such a fall could well have sharply reversed, if and when durable flows reverted to more “normal" levels. The ensuing volatility could have been debilitating for anyone involved in international trade and investments. Given this, RBI was fully justified in stepping in as a market heat sink. Of course, the price at which such intervention should take place still remains an open question. One simplistic measure to judge the “appropriate" value of a currency is the Real Effective Exchange Rate (REER). Here is how it broadly works. Assume that $1 is worth ?75 today. Assume that the price of a widget today is $1 in the US, and ?75 in India. Assume an annual inflation of 2% in the US, and 6% in India. After a year, therefore, the widget would be priced at ?1.02 in the US, and ?79.5 in India. If the value of dollar remained at ?75, we could import widgets from the US at ?76.5 ($1.02 X 75) apiece, much cheaper than the ?79.5 locally. Domestic producers of widgets would be unable to compete, at least till widget prices and currency rates rebalanced. Admittedly, there are several additional factors that need to be considered. Nevertheless, the principle is useful, particularly as India embarks on Atmanirbhar Bharat to raise domestic output and employment. As per the FY06 base year 36-country REER, the rupee was 17.1% overvalued as of January 2021. And as per the FY16 base year 40-country REER, the rupee was 4.6% overvalued as of March 2021 (see Chart 1). With the caveat that the REER has limitations, this does suggest that the value of rupee should further weaken for us to remain competitive.
Impossible trinity
The impossible trinity suggests that a country cannot simultaneously conduct independent monetary policy, remain open on the capital account, and have a stable currency. Beyond this textbook definition, we need a deeper appreciation of how this plays out in India. For a while now, we have been guided by flexible inflation targeting in the conduct of our monetary policy. This framework is silent on the impossible trinity. The implicit assumption is that currency markets should be managed separately, while the MPC uses monetary policy to tackle inflation. However, interest rates set by the RBI via the MPC can impact flows and currency markets more than they impact inflation. Chart 2 illustrates one aspect of how this can and does play out. The black line denotes what we call the dollar-rupee “carry differential". Here is how it works. Consider July 2017. US 10-year Treasury yields were then at 2.3%, while 10-year Indian government bonds were at 6.5%, yielding 4.2% more than US treasuries. At the same time, US CPI inflation was at 1.7%, while India CPI inflation was at 2.4%, or just 0.7% higher. Indian bonds therefore yielded 4.2% more than US bonds, compared to the 0.7% inflation differential between the two countries. Adjusting for inflation, global investors could perceive a “carry differential" benefit of 3.5% (4.2% minus 0.7%) in holding Indian bonds rather than US bonds. Admittedly, many more factors such as inflation and currency expectations go into international investment decisions. That said, note that times during 2011-2018 that were characterised by worsening carry differentials largely saw outflows from FPI debt, while periods of improving carry differentials largely saw FPI debt inflows. FY18 was a particularly notable year. During that year, India saw durable outflows of $16.7 billion across its current account balance, FDI and FPI equity investments. Despite this, RBI net purchased $43.7 billion through FY18, and the dollar weakened against the rupee from 67.5 in January 2017 to 63.8 in December 2017. India also saw reversible “carry" seeking inflows of $60 billion during FY18, comprising of FPI debt and other related inflows. Carry differentials fostered some large volatile, reversible inflows, and altered rupee REER to levels that significantly weakened India’s terms of trade and export competitiveness. The next year, in FY19, much of these reversible flows moved out sharply, causing significant currency volatility. Interest rates had a significant role to play in this build-up, but little of this found any mention in debates around MPC meetings.
forward ops
Another manifestation of the impossible trinity involves the less-tracked currency forward markets. This is tantamount to the RBI placing dollars with the Indian banking system, while borrowing rupees from them. Dollar assets with India’s banking system rose from just ?22,000 crore in March 2020 to ?2.7 trillion in January 2021. In effect, some excess rupee liquidity was replaced by excess dollar liquidity in the banking system. In addition, while the rates implied in currency forward markets are opaque, RBI was effectively borrowing the rupee for up to 1 year through the foreign currency markets at steep rates between 5.00% and 5.75%, in comparison to T-Bill yields of 3.75%. The additional cost through this route in FY21 was around ?9,000 crore to the RBI and exchequer. In addition, the higher implied rupee rates in forward markets invited speculative carry-seeking inflows. While durable flows in FY21 (till February) were at an estimated $104 billion, RBI itself purchased $153 billion across spot and forward markets. The balance $49 billion likely represents substantial and volatile carry-seeking inflows, including speculative sale of forward dollars in the NDF markets. The recent volatility in the currency markets was in part because some of these volatile, speculative positions were nervously exiting. So, what can the RBI do about this volatility? And what should we do with our record levels of forex reserves? First, we must appreciate the immense value of these substantial buffers as we battle through the covid-19 pandemic and beyond. They provide us substantial degrees of currency and monetary policy freedom during these trying times. Second, calls on the RBI to fund infrastructure investments make little sense. If the investments are in rupees, the borrower would simply sell back the dollars, and RBI’s currency reserves would likely be restored. If the argument is that RBI should step in to lend because banks and borrowers aren’t doing enough, that is a case of applying the wrong financial medicine to the right real economy problem. One related area that merits a wider debate is how RBI deploys its substantial reserves overseas. Little about RBI’s overseas investments is public. One presumes that these are concentrated into high quality short-term sovereign bonds and deposits. This conservatism is very welcome. Nevertheless, drawing from the experience of other jurisdictions, we could explore setting up a specialised entity to manage a core part of the reserves, particularly to secure crucial international resources. But first we need a debate about the RBI’s forex management objectives, tools, interlinkages, and outcomes. The opaqueness must end.
Mint, 6th May 2021.
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