Money & Banking

RBI should ‘lean with the wind’ and allow rupee to appreciate: Ecowrap

Mumbai | Updated on November 25, 2020 Published on November 25, 2020

‘Excess liquidity can impact banking sector profits, initiate asset liability mismatch’

Given India’s high domestic inflation, it would do no harm for the Reserve Bank of India (RBI) to lean with the wind and let the rupee appreciate, according to State Bank of India’s economic research report “Ecowrap”.

This would reduce imported inflation and somehow clear the liquidity overhang.

“In fact, the large supply of dollars will ensure that the rupee will not appreciate significantly from the current levels and this could potentially play to the advantage of the RBI even if it takes a hands-off approach for the time being!,” said Soumya Kanti Ghosh, Group Chief Economic Adviser, SBI.

Surplus liquidity, as given by outstanding net LAF (liquidity adjustment facility), stands at ₹5,27,600 crore on as on November 22, with average surplus being ₹4,15,000 crore so far this fiscal.

“One factor which is increasing market liquidity is the RBI’s dollar purchases to prevent further appreciation of rupee. India is classified under the ‘managed float’ exchange rate regime of the IMF. The RBI intervenes in the foreign exchange market to contain excessive volatility as and when necessary and to manage the liquidity conditions. This effectively makes the RBI’s job hard as it is always “leaning against the wind,” Ghosh said.

Forex reserves

Overall, merchant dollar supply is far higher than demand as they anticipate a stronger rupee and, hence, may be holding to a long position in dollars, without even adequate hedging. This is being balanced by excess dollar demand in the interbank market, but the net effect is a large supply of dollars, said the report.

In the current fiscal, the RBI has accumulated $93 billion in forex reserves so far.

Past data indicates that it was only in FY08 that the RBI had accumulated forex reserves more than this amount.

“In the current environment of liquidity surplus, should the RBI continue its intervention in the market and prevent the rupee’s appreciation or should it allow the rupee to appreciate?,” Ghosh wondered.

Liquidity issues

There are potentially two problems if India continues to add to our forex kitty and, hence, liquidity.

“First, the peculiar conundrum when bank loan rates are lower than equivalent rated bonds (for example, 15-year-old spread at a negative 60-70 basis points).

“Such type of irrational pricing, because of abundant liquidity, can impact banking sector profits and initiate asset liability mismatch, if the spread is more prevalent for lower rated borrowers, a sure recipe for financial instability in the future,” Ghosh said.

“Second, we believe inflation is unlikely to come down in a hurry in the current fiscal and it might be only in March that it could get below 5 per cent.”.

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Published on November 25, 2020
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