Volatility in rupee replaced by volatility in reserves

It is a well-known fact that the quality of the Reserve Bank of India’s (RBI) reserves is not that great. Unlike China and Japan whose reserves are predominantly built as a result of trade surpluses, our reserves are largely built with hot money flows. Nevertheless, reserves still do help contain volatility in the rupee.

When the RBI mops up inflows during a federal reserve easing cycle, it prevents the rupee from appreciating. Similarly, when the central bank supplies dollars during a tightening cycle, it prevents the currency from depreciating. This keeps the rupee stable. The wild, exaggerated swings that we used to see earlier in USD/INR have been dampened with the help of reserve build-up and reserve run-down. In other words, the volatility in rupee has been replaced by the volatility in reserves.

A stable currency is a big advantage for businesses and strategic foreign investors alike for it gives a lot of certainty. It reduces the risk premium of INR assets. Selling dollars now is helping the RBI attain two objectives — keeping at bay a source of inflationary pressure in the form of rupee weakness and sucking out system liquidity to facilitate transition towards policy normalisation.

The question on everybody’s mind is how long can the RBI hold fort. Certainly, if the crude prices remain elevated for a prolonged period, it imparts a huge negative terms of trade shock. The moment the situation ameliorates, our macros and BoP (balance of payments) start looking better straight away. So, in that sense, it is quite binary. A lot is predicated on how the war pans out. We believe the RBI can contain volatility in the near-term but the longer crude prices stay elevated, the more nervous the markets will get. We see a 76.40-77.90 range for the rupee for the next 6-8 weeks.

Since the day Russia invaded Ukraine, February 24, the rupee had been outperforming its peers. Even after the recent move, the rupee still has depreciated only 3.7 per cent compared to the Thai Baht, Korean Won, Yuan and the Taiwanese Dollar which have depreciated 4 to 7 per cent since the war began.

Abhishek Goenka, Founder & CEO of IFA Global

Equities

Who will prove smarter, FPIs or the dip buyers? With the RBI having initiated policy normalisation through an out-of-the-policy repo and CRR hike, the risk-free rates have spiked up. The rates are very lucrative in the 3–4-year window. This would increase the expected return on equity and dampen retail investor participation to some extent.

However, high frequency indicators are pointing towards a pick-up in consumption and investment activity. If inflation relents, we could see aggregate demand being supported, which bodes well for corporate earnings. Bank balance sheets are in a relatively good shape and banks are well positioned to cater to the borrowing requirements of businesses.

Overall, we believe Indian equities would continue their relative outperformance but we still see pain in the short term. We personally do not expect double-digit returns for some time now, since the global interest rates cycle has turned. In equities, it is recommended to stick to the index for the time-being to wade through current global uncertainties.

Domestic bonds

Would the massive government borrowing go through in a non-disruptive manner? Can the RBI help ensure it does so? The budgeted gross borrowing for FY23 is ₹14.3-lakh crore, of which, ₹8.45-lakh crore is to be borrowed in the first half of the fiscal (H1 FY23).

It is unlikely that such a massive borrowing programme would go through smoothly without RBI’s support. Moreover, capping long-term yields is crucial given the focus on capital expenditure (capex) in this year’s Budget and also considering the fact that government expenditure is needed to drive growth with personal consumption still recovering. Robust tax collections could be offset by fuel, fertiliser and food subsidies, given the elevated global food and fuel prices.

The out-of-the-policy tightening by RBI has jolted bond markets. The central bank would have to step in and conduct OMOs (open market operations) to soothe the bond markets at some stage. One of the major constraints in RBI supporting government borrowing has been the banking system liquidity surplus. The RBI cannot keep system liquidity in a huge surplus when it is looking to normalise monetary policy.

The RBI had been draining liquidity through outright FX sales and FX sell-buy swaps. In FX swaps, the RBI has succeeded in adding another liquidity management tool to its toolkit. However, the sheer quantum of the surplus forced the central bank to go for a CRR hike. The rise in currency in circulation, too, is draining the surplus liquidity. Return of banking system liquidity to neutral would open up room for the RBI to support government borrowing.

We see the yield on the benchmark 10-year trading in the 6.90 per cent-7.75 per cent range in FY23. The curve has completely bear flattened with 2026 securities available at 7.06 per cent and 2032 benchmark trading at 7.30 per cent. Considering the low credit spreads, we believe it is better to stick to Government Securities instead of corporate bonds and State Development Loans. We suggest adding duration on upticks.

Impact on FII, FDI flows

We have already seen an FPI outflow of $23 billion over the last eight months from equity and $3 billion from debt. With the Fed having toned down its hawkishness in the latest policy, we expect the pace of outflows from domestic equities to slow down.

Fed chairman Jerome Powell said it is not actively considering a 75 bps hike. We feel the Fed may have to tone down its hawkishness further after another 50 bps of hike. We see the terminal rate in this hike cycle at 2.5 per cent. We expect the pace of FDI to be steady at $4 billion a month.

Impact on export

Exporters are advised to keep adding hedges through a combination of forwards and risk reversals (RR), of which the latter would help them retain participation in case the rupee depreciates. Importers are advised to cover their exposure on dips through forwards. They can consider hedging a part of their exposure through ATMF (at-the-money-forward) or slightly OTM (out-of-the-money) call options to benefit, in case there is a quick reversal in USD/INR.

These options would, however, be expensive as volumes have shot up with the move higher in spot. Three-month ATMF volumes are now at 6.5 per cent.

It would be important for the RBI to prevent a speculative build up as that can result in a run on the rupee. It needs to use the reserves judiciously to manage the currency and would have to intervene aggressively at times to deter speculators as soft touch intervention would not be very effective. The RBI is likely to intervene through a combination of spot dollar selling in OTC (over-the-counter), selling in exchange traded futures and selling in NDF (non-deliverable forward). Doing more sell-buy swaps to keep the forward premium in USD/INR elevated would also help deter speculators to some extent.

(The writer is the Founder & CEO of IFA Global)

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