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Informist, Monday, Dec. 16, 2024

 

By Pratigya Vajpayee

 

MUMBAI - When Sanjay Malhotra faced the media for the first time after taking over as the governor of the Reserve Bank of India on Wednesday, there were two main subjects on which markets awaited his views with baited breath. The first, unsurprisingly, was the monetary policy, and the second was the exchange rate of the rupee.

 

Malhotra's appointment comes at a time when the central bank's current foreign exchange policy is increasingly being termed as being futile, unsustainable, and even counterproductive. A change of command offers an opportunity for a reset.

 

For over a year now, the RBI has been intervening aggressively in the currency market to prevent even moderate movements in the rupee's exchange rate. It's been buying dollars to beef up its foreign exchange reserves when the rupee is strengthening, and deploying these dollars when the rupee is weakening. The limitation of such a strategy is that it becomes hard to sustain if the depreciation pressure is persistent, as the RBI's ability to sell dollars is constrained by the level of its reserves. This is precisely the situation RBI finds itself in right now.

 

Since October, the rupee has been falling because of large and persistent foreign investment outflows spurred initially by geopolitical tensions as well as the lure of economic stimulus in China, and later by the uncertainty over US economic policies as Donald Trump prepares to return to the White House. From the looks of it, the rupee's weakness is unlikely to dissipate anytime soon as Trump's proposed policies are likely to strengthen the dollar even further.

 

In such uncertain times, prudence lies in using foreign exchange reserves judiciously. But the RBI's insistence on fighting all odds to prevent the rupee from depreciating significantly has cost it over $50 billion in reserves since early October. Even against the depleted reserves of $654.857 billion as on Dec. 6, the central bank has a massive liability in the form of outstanding forward dollar sales. These were known to be at $49 billion at the end of October, a number that is expected to have ballooned further in November. However, to be fair, a large part of these forward dollar sales is expected to be in the non-deliverable forward market. While the NDF sales won't require delivery of dollars, the RBI will still be required to book the loss, or profit, as the case may be. And while this number is expected to be small given the size of the RBI's balance sheet, it is still an exposure.

 

The rapid depletion of reserves has already started raising concerns about the RBI's ability to protect the rupee against speculation if market conditions turn more unfavourable. If anything, the RBI's current intervention policy sets the rupee up for speculation by making the currency even more overvalued than it was at the end of September. What's more, the RBI's large forward dollar sales create a drag on dollar/rupee premiums, making it cheaper to speculate against the rupee. In fact, those speculating against the rupee have little to lose because the RBI is expected to buy dollars massively even if the rupee were to start appreciating. The RBI's intervention policy essentially makes speculating against the rupee a no-loss trade. Emkay Global Financial Services, in its latest note summarising the concerns of its clients, said "there was uneasiness around RBI's dirty FX management, which some fear could lead to bigger financial stability-risk later".

 

The biggest and perhaps the only beneficiary of the RBI's intervention policy are the foreign investors, who get to pull out their capital at overvalued rupee valuations, with the opportunity to re-enter Indian markets at a cheaper currency valuation. Given the drawbacks of the RBI's intervention policy, markets are puzzled as to why the central bank doesn't simply allow the rupee to depreciate and in fact, use the opportunity to correct the currency's valuation.

 

Some believe the strategy to not let the rupee fall is driven by the government's preference for a strong currency as it makes for better optics. Or perhaps the RBI is worried that letting go at the current stage will create panic and destabilise markets. The RBI's tight hold on the exchange rate over the last year has lulled corporates and financial market players into leaving currency risk unhedged. Still, there is a widespread belief that rupee depreciation is inevitable, and the more the RBI prevents it, the more drastic will be the correction. A telling sign is that even exporters have turned speculators, and have been putting off dollar sales waiting for the rupee to reach more realistic valuation.

 

In Malhotra, markets see hope. As a direct import from the finance ministry, Malhotra is expected to be particularly sensitive to the need to support India's slowing economic growth. With an overvalued rupee seen as a threat to export competitiveness, a growth-supportive foreign exchange policy makes a case for a weaker currency. Even if the new governor is not looking to make any sweeping changes just yet, now would definitely be a good time to review the RBI's strategy in the currency market. In letting the rupee fall, Malhotra can also take solace in the fact that in recent history comparably long periods of calm in the local currency market have always been followed by a sudden and sharp fall. It has been almost as if the RBI is daring the market – let me see how low you can take the rupee.   End

 

US$1 = INR 84.8250

 

Edited by Ashish Shirke

 

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