The Hindu Business Line : Currency swap curve moves higher

Expectations of a strong rupee and thereby continuous exporter selling and the reluctance of the banks' balance sheets to swap their dollars into rupees for longer periods had held the forward curve much lower than the money curve for a long period.

ANY international finance textbook will tell you that the forward rate or the swap differential for any tenor is nothing but the interest rate differential between the two currencies for that tenor. However, this has not been the case with the rupee currency swap curve for a very long time.

But for a few corrections, on the back of good invisibles and capital flows, the rupee continued to strengthen against the dollar since March 2002.

Since around that time, the country maintained a healthy current account surplus that provided comfort to the exporters to sell their forward dollar inflows, whereas the importers left their exposures largely unhedged. The country's comfortable balance of payments position and global dollar weakness made the short dollar against the rupee an almost `no brainer trade'. At one point, every one and their uncles were sitting on this trade.

In its bid to slow the rupee appreciation, the central bank had to intervene aggressively in the spot market. A combination of forward sales by corporates and spot intervention by the central bank caused an acute shortage of dollars in the banking system, which pushed the dollar-rupee forwards to abysmal levels. Banks were ready to do buy-sell swaps at any level to save themselves from defaulting on their nostro balances.

Eventually, the dollar shortage situation did clear up, but it got distinctly etched in the memories of the banks' funding departments. Even if the overnight rate went to 6.00, none of the balance sheets paid the long forwards as the dollar shortage story was still fresh in their minds. Expectations of a strong rupee and thereby continuous exporter selling and the reluctance of the banks' balance sheets to swap their dollars into rupees for longer periods had held the forward curve much lower than the money curve for a long period.

Things have changed a bit in the last month. On the back of higher rate expectations, the dollar started to recover against all major currencies. Meanwhile, the country posted a large current account deficit in the June-September 2004 quarter, the data for which came out only by end December.

The $6.4-billion current account deficit for the quarter was due to surging imports, slowing invisible flows and high oil prices. The global dollar strength and a large current account deficit forced people to revisit their dollar-rupee view.

From the dollar being a `no brainer sell' against the rupee, people started to revise their outlook to a more balanced one. We saw the forward sales by corporates almost dry up. Also, the domestic stock market, which had seen unprecedented portfolio inflows in November and December, started to see FII outflows in January.

The market that had gone up too much too soon started to see a large correction. To top it all, there were reports of the central bank buying dollars and paying on the forwards to cover a part of the India Millennium Deposit outflow scheduled for December 2005.

All these factors together, pushed up the currency swap curve sharply higher. Balance sheets slowly shed their dollar shortage fear and started to pay the forwards, as it was the cheapest source of funding.

We have seen various newspaper reports that have talked about banks garnering deposits for three to six months at rates close to 6.50 per cent. The one-year implied rupee yield through the forwards hung around 4.85 per cent long enough to give the balance sheets some room to raise cheap funding. It has now moved to 5.25 per cent and has been hanging around there for the last week.

Although it is still much lower than the current 1 year T-bill rate of 5.65 per cent, the market clearly seems reluctant to take it any higher. For now, 5.10-5.40 per cent looks like its range unless one of the fundamental drivers changes.

We have the G-7 meet on February 4 where the revaluation of the Chinese yuan may be discussed. Anything that brings us closer to the revaluation of the Chinese currency is sure to bring cheer to the rupee bulls and, hence, could cause the forwards to drift lower. However, any knee-jerk appreciation in the rupee, on the back of the revaluation news, will leave the forwards unchanged as you will then find few sellers of dollars at the lower levels.

The stock market has started to gain strength again and we have seen some FII inflows in the last couple of days. If the trend continues, then we could see some dollar sellers come back to the market. However, one has to wait for the corporates to start selling forward dollars again before receiving the currency swap curve in any meaningful manner because the 5.10-5.40 range on the one year does not look like breaking without customers selling in large.

The one-cross five spread on the currency swap is at a record low of almost 50 basis points. It looks unlikely that it will shrink much from this level unless the whole curve continues to move much higher. From a risk reward point of view, it might be worth paying that spread.

The author is senior trader, interest rates at HSBC, Mumbai. The views expressed herein are his own and not necessarily those of his employer.

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