The impossible task of taming the rupee

Most currency market watchers were surprised at the Indian rupee’s weakness in 2020. In a year when currencies of other emerging economies such as China, South Korea, Taiwan and the Philippines gained more than 5 per cent against the greenback, the rupee declined 2.3 per cent. This was despite all emerging economies being in similar straits, trying to manage the gush of foreign funds entering their shores.

The rupee’s weakness can be traced to the RBI’s forex market interventions last year; the central bank net purchased dollars amounting to $87.7 billion in 2020, curbing a strong rally in the currency. The central bank has however been unable to maintain the pace of intervention in 2021, though the rupee continues to be on a strong footing.

The negative repercussions of the central bank’s dollar purchases on domestic liquidity, inflation and quality of assets in the central bank balance sheet are factors that may have made the RBI go slow with forex market interventions this year.

While the central bank is trying to adopt other strategies to control rupee appreciation this year, the task is not easy given the extraordinary conditions caused by the pandemic.

The rupee has been quite volatile in 2021, whipsawing in a range between 72 and 75 against the dollar. Despite this indecisive movement, various factors point towards continued strength in all EM currencies including the rupee, going forward.

One, the US Federal Reserve’s continuing bond purchases over the coming months, albeit at a tapering pace and the promise of low interest rates until the end of 2022, will keep the dollar weak.

The US dollar index, which tracks the movement of the dollar against a basket of currencies, is in a structural downtrend since 2002 and the Fed’s expansionary policy is unlikely to help. This will lead to rupee appreciation against the greenback.

Two, strong portfolio and FDI flows into EMs is likely to continue as long as interest rates in G3 countries stay low. The effect of these flows on currencies is already evident in the EM currencies such as the South African rand, Taiwanese dollar, Russian rouble and the Chinese renminbi, which have gained more than 1 per cent against the dollar so far this year.

While the rupee is almost unchanged, thanks to the RBI’s intervention, the central bank may not be able to help for too long.

RBI’s dilemma

This is because of the impact of the RBI’s forex market interventions on liquidity in the system. Purchase or sale of dollars for market intervention tends to impact domestic liquidity. While purchase of dollars increases liquidity, sale results in sucking liquidity out of the system.

The RBI had to net purchase dollars worth $87.7 billion in 2020 to mop up the dollars entering the country due to the copious FPI and FDI flows. FPI flows in 2021 have continued to be strong, amounting to ₹74,713 crore so far, maintaining the tailwinds for rupee appreciation. FDI and ECB issuances have also been strong this year.

But the central bank has been more cautious about intervening in the spot market for the rupee this year, due to the impact on system liquidity, which is already at record levels due to poor credit off-take. The increase in liquidity is not only inflationary, it also impacts interest rates in the economy, taking it below desired levels. The RBI’s net purchases of dollars between January and June this year amounted to $24.6 billion, 13 per cent lower compared to the same period last year.

But while decreasing its activity in the spot market, the RBI has been increasing its interventions in the rupee forward market since last November. Outstanding rupee forward positions amounted to $13.5 billion towards the end of October 2020. But it had jumped to $72.7 billion by this March and was close to $50 billion by the end of June 2021. Such large-scale intervention in the forwards market has, however, had the negative impact of expanding the forward premia, hurting corporates with hedging positions.

The central bank is clearly in a difficult situation. Conventional form of sterilisation through open market operations is difficult currently, given the need for the RBI to support the government’s large borrowing. In the past, banks’ CRR had been hiked to absorb liquidity, but the RBI may not want to burden banks in any way until the pandemic abates.

The other way in which the RBI could sterilise the liquidity injected through forex interventions without impacting domestic liquidity is through MSS (market stabilisation scheme) bonds. But the fallout of such an announcement would be to harden yields due to additional supply of sovereign paper. This could attract more FPI inflows into debt, causing a chicken and egg situation.

Another negative fallout of excessive dollar purchases is the increase in low-yielding foreign currency assets on RBI’s balance sheet.

The impossible task ahead

It is fairly well-established that it is impossible to have the trinity of a fixed foreign exchange rate, free capital movement and independent monetary policy. But given the unprecedented crisis caused by the pandemic, keeping the exchange rate under check, even with capital control and a pro-active monetary policy, is becoming a difficult task not just for the RBI but for most central banks of emerging economies. Most emerging economies have seen their foreign exchange reserves increase sharply since last March as portfolio flows increased from the second quarter last year.

As long as easy monetary policies of the US, ECB and Japan continue, foreign fund flows into India are unlikely to abate. With the central bank is in a tight corner due to surplus liquidity and large government borrowing, its ability to actively intervene to stem the rupee appreciation could get limited.

But a stronger rupee may not be so bad for the economy. It can help reduce imported inflation and lesser forex interventions could also help reduce the liquidity surplus. With forex reserves at a record high and global central banks being very careful to not destabilise markets, threat of taper-induced volatility is also declining rapidly.

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