India’s currency, bond and money markets have each seen their share of the drama over the past year as the Reserve Bank of India battled exceptional circumstances amid the Covid crisis.
In doing so, India’s central bank has stepped up its intervention in the markets to maintain what Governor Shaktikanta Das has called “friendly” financial conditions. But interventions in one market segment have inevitably led to anomalies in others.
Call it the RBI mole problem.
The most recent market to see this game has been the forex market.
During the months of April and May, concerns arose about an increase in dollar / rupee term premiums. 12-month term premiums jumped to over 5% in early May, but have since fallen below 4.5%. Simply put, term premiums are the difference between the dollar / rupee spot rate and the term rate, say a month or three months or a year later.
What led to the rise in futures premiums is an episodic narrative with an underlying factor – the RBI intervened more than ever through the rupee futures market.
Data available in March shows the RBI had an outstanding dollar futures position of nearly $ 73 billion. According to Vivek Kumar, an economist at QuantEco Research, this is the highest ever.
While the RBI often intervenes in foreign exchange markets, both to prevent undue appreciation and depreciation, its intervention is primarily through the spot markets. Here, either he buys dollars, in turn freeing up rupee cash, or he sells dollars, absorbing rupee cash.
Over the past twelve months, however, the rush for foreign inflows has been strong, with India receiving $ 36.2 billion in REIT flows, the highest since 2016-17. Add to that record FDI inflows of $ 81.7 billion.
This forced the RBI to intervene not only through spot markets, but also through futures, as it tried to prevent a sudden appreciation of the Indian rupee, which could hurt India’s export prospects. while leaving it vulnerable to strong corrections later if the flows were to reverse.
There are a number of theories as to why the RBI began to intervene more in futures contracts than in the spot market.
One theory says that the central bank did not want its balance sheet to grow too much because that would have forced it to set aside more reserves, which would have led to a smaller surplus transfer to the government. Buying foreign currency in the spot market immediately increases the size of the RBI’s balance sheet, which is made up of domestic assets, such as bonds, and foreign assets, i.e. foreign exchange reserves.
The central bank, however, maintains that balance sheet considerations do not determine its approach to managing foreign exchange.
Another explanation is that given the already large excess liquidity in domestic markets, the RBI may not have been keen to add to it via heavy spot currency purchases. This liquidity would have returned directly to the RBI through the reverse repurchase window, and at some point the central bank might have started to exhaust the pool of securities it offers to those who place funds in the window. reverse pension. Banks were parking between Rs 6-7 lakh crore with the RBI at this time and government cash balances were also high.
A third possible explanation is that tools used in the past to mop up excess liquidity generated by foreign exchange flows, such as the market stabilization mechanism or MSS bonds, were not considered a good idea in the context. current because they would have added to the already heavy supply of government paper on the market. In such a scenario, the RBI used whatever tools it could.
This is where we come back to the mole analogy.
The reason this situation occurred is that the RBI was not willing to let the dollar / rupee find its own level. For good reason, yes. But because the RBI intervened heavily to keep the rupee spot rate stable, it ended up skewing forward premiums.
Certainly, in addition to the RBI’s intervention strategy, a few other factors may have played a role in the volatility of the futures market.
Large influxes related to the Powergrid InvIT caused part of this. A change to the RBI’s large exposures, which essentially limited the dollars that foreign banks could park with their parent entities, also played a role, according to forex traders.
Term premiums have now stabilized at more reasonable levels.
Madhavi Arora, economist at Emkay Global, said the RBI has started to unwind some of its futures positions and take delivery of upcoming maturities. It was also found to be taking early deliveries. This helped push down forward premiums, which Arora said had increased due to the combination of the factors discussed above.
She added that as term premiums increased, it might have made more sense for the RBI to absorb cash at 3.5% through its reverse repo window rather than paying more than $ 4. , About 5% on the futures market.
In addition, foreign inflows have moderated.
Even though term premiums have come down, they remain above historical averages, Kumar said. He added that given the narrowing inflation gap between the United States and India, premiums might have been expected to go down, but they are not.
Ultimately, a higher premium makes it more costly for companies to hedge their forex exposure and discourages them, Kumar explained. This can come at its own risk down the line. Arora shared this view, warning that uncomfortably high premiums could still emerge at times when sudden and large inflows are seen.
The act of juggling the RBI is forced into in the forex market has a parallel in the bond and money markets.
At first, when the RBI flooded the system with liquidity, much of it rushed into short-term commercial paper borrowing. The result was that for a while the government and even some well-rated companies borrowed at rates below the RBI repo rate, rendering monetary policy ineffective in some ways.
The RBI addressed this issue by restarting floating rate reverse repurchase transactions.
Around February, markets started to increase the benchmark 10-year yield, both due to high government borrowing of Rs 12 lakh crore for the current year and due to the expected political normalization over the course of the year. year.
The RBI thought it was too early for benchmark rates to rise, so they started buying these securities through open market operations, secondary markets and, more recently, its G-SAP program. As Bloomberg reported, the RBI now owns more than 50% of the benchmark stock.
As the RBI focused on the 10-year, other segments of the market began to see their rates rise. These were first yields on 5-year bonds, then yields on longer-term bonds and, more recently, government bonds. The RBI had to step in to cool each of these markets from time to time.
Moral of the story: no action is without reaction.
The RBI’s juggling act is unlikely to end anytime soon if it feels that controlling rupee and benchmark returns is the way to go. Maintaining the independence of monetary policy while allowing a constant flow of foreign capital and keeping a stable currency is called “The Impossible Trinity” for a reason.
Ira Dugal is Editor-in-Chief at BloombergQuint.
The author would like to thank Vivek Kumar, economist at QuantEco Research and Madhavi Arora, economist at Emkay Global for their contributions.