USDINR : Latest RBI Action

INR Free Fall

The Indian Rupee has been in a free fall for the past two months. What started off as an incremental de-pricing has now evolved into frantic selling and investors moving back to the safe haven of the dollar.
 
But the Reserve Bank of India, has not been a mere spectator. It has swung into action as it always has, this time utilizing its massive war chest of more than $580 billion to stabilize the price of the Rupee. A weak currency result in a higher Current Account Deficit (CAD), fuels inflation and slows down international trade; so it’s only natural that RBI takes it upon itself to correct the situation on behalf of the Govt of India and the citizens.
 
Have you ever wondered how the RBI does this? Let’s break it down and simplify it.

RBI Action To Stabilize INR

We have already established RBI’s need to control the volatility in the value of the Rupee. USDINR is the most liquid currency pair for that, and most of RBI’s interventions are aimed at stabilizing this pair. As you might already be aware, the FX markets are highly volatile and extremely speculative. And this speculation is what actually creates short-term price shocks in our markets too. So, RBI’s main agenda is to reduce this speculation. Towards this, there are four major measures that RBI implements:

1. Limit borrowing by banks: Banks love to borrow from RBI due to competitive costs. After all, cheap credit is what fuel expansion in a growing economy. Some of the borrowed money (in dollars) is used by the banks to speculate on their own (!) in the forward and spot FX markets to create an arbitrage opportunity. Not only this, but too much borrowing also comes at a cost. Hence, RBI makes it difficult for banks to borrow by increasing costs and capping the amounts. This forces banks to look at the market for borrowing funds, which is more competitive, and in turn, discourages speculation from their side.
 
2. Increasing Interest Rates: Higher interest rates encourage foreign investors to bring in more investments into India. This is a no-brainer as interest rates in the US and Europe have been at their lowest for almost a decade. This measure encourages the FPIs to buy INR so as to invest in Indian securities and bonds, by selling their dollars. In turn, this creates a demand for INR and helps in increasing its value vis-a-vis the US Dollar.
 
3. Increasing the Cash Reserve Ratios (CRR): A higher CRR means that banks have to keep more spare cash with the RBI, thereby leaving them with less cash to speculate with. RBI has also tweaked its policy to ensure banks keep the higher CRR on a daily basis, instead of fortnightly. Remember that RBI allows exemptions on this for NRE deposits, so as to stimulate more foreign remittances from NRIs living abroad. This happens because the banks will now reach out to more NRIs and offer higher returns on their forex deposits.
 
4. Selling USD on NDF and Spot FX Markets: This is the most interesting short-term action that RBI executes to cushion the fall of the Rupee. USDINR is traded on two major types of markets: the spot market and the Non-Deliverable Futures (NDF) market. As the name suggests, the spot market is where FX pairs are traded for immediate delivery on an exchange, whereas NDF markets are mostly Over-The-Counter (OTC). NDF markets are used to trade illiquid currencies for speculation and also to hedge risks by large players. USDINR is one of the largest NDF markets in the world, with South Korean Won, Chinese Yuan and Brazilian Real also being some of the heavily traded FX pairs.

NDF markets are usually located offshore of the illiquid currency, with London being the largest trading location while considerable trading happens in New York, Singapore and Hong Kong. But interestingly, India has an onshore NDF market too in GIFT City, Gujarat with monthly volumes as high as $27 billion. It is important to note that the offshore NDF markets trade at a premium to the onshore markets, creating high arbitrage opportunities. Speculators with easy access to USD, thus, bet heavily against the INR. This is when RBI enters the market with its massive war chest of FX reserves – currently at more than $580 billion – by selling USD and neutralizing the arbitrage opportunity. This creates an artificial demand for the Rupee and hence increases its value against the USD, thus resulting in a temporary stabilization of the currency.
 
This cat-and-mouse game continues until RBI decides that a generally fair value has been reached for the time being. However, with other macroeconomic indicators triggering again – like Fed rate hikes which make FPIs leave Indian markets for the US or high oil prices – this price action continues at a later time frame.

How Long Can RBI Fight the Fire?

Of course, RBI cannot keep selling precious foreign exchange to defend the Rupee. India needs its forex to pay for its imports (mainly oil, which is denominated in the USD) and thus, needs to find a long-term solution to the problem.
 
There are three major actions that India needs to do if it has to ensure a stable and strong currency:
 
1. Reduce dependence on oil, or find ways to import it in Rupees
2. Increase the export base, thereby bringing its CAD under control
3. Improve macroeconomic indicators in the economy, thereby, luring FPIs to invest more in India
 
As we are seeing from the rapidly-changing geopolitical scenario, India might just pull off a deal with Russia to import oil in Rupees. With more than 70% of the import value coming from oil, this would mean a strong reversion in the USD/INR rate. India is also making progress in enhancing its manufacturing capabilities which would result in more exports and thus more foreign exchange. This helps lower the CAD, and in turn, raises the global rating for the country. A better rating means more investments from FIIs and FPIs, and more capital for domestic businesses, thereby bringing in a “positive vicious cycle” effect.
 
Until these happen, RBI will have to fight the fire in the best ways it can.