USDINR in September 2017 - Quo Vadis?

Written on 28th September 2017 morning..

Commentators have expressed surprise at the sharp move up in USDINR, from 63.80 just 20 days ago, to over 65.80 now. What has caused this sharp move up? Who has been buying USD? We were just celebrating the rapid rise in RBI's FX reserves t beyond $400B, what has changed the past 3 weeks?

All legitimate questions, and am sure answers will emerge. However, I believe that to understand the sharp move up, we have to understand the vulnerability that built up over time. A pertinent question to ask is - who was selling USDINR earlier? Since the beginning of 2017, RBI has net purchased over $25B in the spot market, in addition to over $30B in the FX forward market. Where has all this FCY come from? 

India's current account deficit is barely covered by our FDI net inflows and FPI investments in equity. These are the closest to permanent sources of FCY into any country. So if permanent net sources of FCY cannot explain the $55B of FCY mopping up that RBI has done since the beginning of the year, there must have been an implicit increase in unhedged exposures. 

In other words, exporters have probably net sold forward FCY well in excess of importer forward covering, Indian entities have probably left FCY debt unhedged, and FPI in debt has likely come in unhedged. All this are transient, rather than permanent inflows -  buying from importers and debt repayment has to catch up at some stage, particularly with a growing trade deficit.

With such large one-sided positioning, violent market corrections are always a possibility. 

So why has this vulnerability of unhedged FCY exposures built up steadily over the year? First off, every market is susceptible to a herd mentality. The temptation to do as your neighbour does can be irresistible. Particularly since the BJP win in UP in February, and post the implementation of GST in July, the feel-good about Indian assets was strong. 

Second, the cost of buying forward USD - the USDINR forward premia - is seen as high. Even today, 1-year USDINR forward premia is close to INR 2.80. This is on account of two issues. First, with our inflation-centric monetary policy framework, domestic real interest rates appear high. This is a reflection of the impossible trinity - we cannot have an independent monetary policy alongside free capital flows and a stable currency simultaneously. Second, RBI has been buying a big chunk of its USD in the forward, rather than spot market, in order to avoid the INR liquidity infusion that a spot USD purchase entails. This in turn keeps the forward premia supported, and incentivises further buildup in unhedged exposures. Given interest rate parity does not work perfectly in India, if RBI had chosen to stay away from the forward market, forward premia could have come down to levels that beget more balanced hedging flows. Perhaps liquidity implications could have been handled entirely through money market operations.

In this connection, an observation regarding offshore positioning. Besides unhedged FPI exposures, there could be large speculative long INR position build-up offshore, witness the fact that NDF forward premia were consistently lower than onshore points, until the recent volatility began. It is also possible that merchanting trades, allowed in India the past few years, were one conduit to bridge the onshore/ offshore markets, and effectively bring offshore positions onshore.


So where do we go from here? The good news is, RBI has the offsetting USD to all the unhedged positions that were built up. It has ample ammunition to stop INR depreciation whenever it chooses, in the short run. Questions remain, of course. For one, the RBI and MOF could want a weaker INR, as one way of controlling a widening current account deficit, and to foster domestic industry. Second, the RBI might want to ensure that there is a shakedown in the size of the unhedged positions, so that this cycle does not repeat. A bout of volatility might just be the medicine needed to control unhedged exposures. You don’t want the market to build up positions, with the comfort that RBI is there to bail them out, should the sentiment turn.

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