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S. Balakrishnan

WHAT the corporates most want, the RBI is trying to take away.

In recent months, the forward premium on the dollar against the rupee has dwindled to almost nothing. In fact, for near maturities, the US currency is at a discount. Thus, one can buy one or three-month dollar cheaper in the forward market compared to spot. Even for 12-month delivery, the buck is almost on a par with spot.

It is a sea change from the situation prevailing a couple of years back. Then, it was the other way round. Forward dollar premiums exceeded the rupee-dollar interest differential making a rupee liability - dollar asset mix profitable. Today, the equation is entirely different. An investor whose base currency is the dollar can earn 4-5 per cent on one-year rupee investments and hedge the exchange risk at zero cost, keeping the rupee return intact in dollar terms.

As US interest rates are just 1 per cent (money market mutual funds offer barely positive returns), a dollar investor earns 4-5 times more in arbitrage between the US currency and rupee.

The RBI is not comfortable with this state of affairs. It has valiantly tried to drive down the rupee in the spot market, hoping that the effect of its intervention will spill over to forwards. But they have stubbornly refused to move upward. In fact, even as the central bank was in the market buying spot dollars, forward premiums collapsed.

An obvious arbitrage opportunity was eliminated when the rate of interest on NRE rupee deposits was brought down to just 25 basis points over dollar interest rates for the same maturity. In effect, external rupee deposits cannot enjoy domestic interest rates with convertibility privileges, given the low levels of dollar-rupee forwards.

Of course, flows into bank deposits are just one stream. Overseas investors can still invest in short-term debt paper of Government and other issuers and reap the benefit of arbitrage.

Equity flows, FDI and remittances are the major sources of dollar supplies. This is the price - if one may call it that - of a rerating of India's prospects on the part of global investors.

Because of the RBI's absorption of spot dollars, paradoxically, the inter-bank market is short of dollars, despite the large inflows. This is where corporates come into the story. They would clearly love to substitute their rupee liabilities with dollars and slash their interest cost by several percentage points after costing the dollar rupee hedge.

To contain large-scale liability swaps to dollars, the Government and RBI have recently tightened the regulations on external commercial borrowings (ECBs), restricting them to defined end uses. The fear is that unrestricted growth in corporate forex debt could lead to increased financial risks and volatility in currency markets. The RBI has been constantly warning corporates about their unhedged forex exposures.

Beyond all this is the policy issue of the extent to which balance sheets can be allowed to be fungible between domestic and foreign currencies. There is almost complete capital mobility but it constrains and sometimes undermines domestic monetary policy, as now.

The RBI does not want to go soft on interest rates till inflation comes down significantly, yet our relatively high interest rates are the magnet for offshore investors.

The central bank wants to keep the exchange rate down, but this is creating unwanted liquidity. Truly a problem of having to square a circle.

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RBI trying to square a circle

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