The Great INR Carry Trick

For a while, ignore the breathless headline that INR is at a 2.5 year high against the USD. Also ignore the valid counter-argument that looking at USDINR alone is misleading, and that INR actually weakened by 7% against the EUR the past year.

Both statements are true, but tell us very little about the “right” value of INR. 

Let’s instead take a look at the USD inflows that are adding to RBI’s growing FX reserves. A significant chunk of the inflows chase the prospect of better “carry” in INR, and are reversible. Though this is not acknowledged or debated enough, our monetary policy framework and RBI’s specific FX intervention methodology have played a role in making this “carry trade” attractive.

Dollar, dollar everywhere…

Over many quarters now, RBI has intervened and bought USD in FX markets. In fiscal year 2018 (FY18) till October 2017, RBI purchased over $17B in the spot market and over $20B in the forward market. What are the sources of this plentiful USD? 

The net flow in FY18 across our current account deficit, FDI, and FPI in equity is negligible. These more permanent flows are not the ones filling up RBI’s coffers. 

Instead, flows have come in debt FPI, net forward exporter hedging, repatriable NRE deposits, and old-fashioned speculative positions. These flows follow the same broad logic. If the “carry” earned by converting USD into INR is more than eventual INR depreciation against USD, these bets make sense.

Let’s take specific examples. Debt FPI can earn 7.25% in INR, rather than 2% in USD – a net “carry” of over 5%. Similarly NRIs can earn 7.25% tax-free interest on their 3-year NRE deposits, against 2% in USD. Exporters and FX speculators earn a “carry” of INR2.75 for every dollar by locking into the 1-year USDINR forward rate. 

As long as INR depreciation against USD is less than this carry, selling USD and holding INR makes sense. As it turned out in 2017, INR actually appreciated by 7% against the USD. Rather than FX movements eating into carry, it added a nice windfall to the FPI/ NRI/ speculator/ exporter.

In FY18 so far, we’ve seen over $18B of FPI flow into INR debt. NRI tax-free repatriable NRE deposits have grown from $49B in October 2013 to $86B now. Offshore long INR speculative positioning has been high, and some of this has made its way into onshore markets through merchanting trade arbitrages. 

These flows can be fickle, so if the market ever veers around to the view that INR depreciation can exceed the carry, these flows can stop or actually reverse.

As I have written in a previous note (see 1), cumulative reversible exposures chasing this great carry hope trade have risen by over $100B since FY14.

Monetary policy, RBI FX intervention & the carry game

Many components of the carry trade are directly linked to monetary policy and the manner of RBI FX intervention.

Monetary policy has a bearing on general interest rates in our country, including bond yields, NRE deposit rates, and USDINR forward premia – all key components of carry. As is well recognized, the famous ‘impossible trinity’ postulates that we cannot have an independent monetary policy, stable currency and free capital flows co-exist over time. 

In addition, RBI’s forward FX intervention and volatility management has added to the attractiveness of the carry trade. Let’s look at this a little further.

When RBI buys USD in the spot market, it releases INR liquidity into the system. RBI doesn’t like INR liquidity lying around, and so has to absorb it using money market instruments such as OMO and reverse repo. But by buying USD in the forward market rather than spot, RBI avoids immediate INR injection altogether.

As a via media, RBI ends up doing a bit of both – a bit of spot FX intervention followed by liquidity management, and a bit of forward FX intervention. Doing partly this and partly that sounds like a good balance, except it’s not – at least, not under all circumstances. 

Forward market USD purchases by the RBI supports forward USDINR premia, and incentivizes more exporter and speculator selling of USD. India is not a capital account convertible country where forward FX prices quickly equalize to interest rate differentials. In the current context, RBI should instead undertake spot intervention alone, and use money market tools to manage liquidity. Staying away from the forward market (and tweaking some regulations, if needed) can help ease USDINR forward premia down to levels that reduce carry attractiveness, while inducing some spot FX volatility as well. 

On volatility, RBI has both bought and sold USD at different times to arrest sharp spot FX moves. Managing volatility is laudable, but it breeds complacency. A combination of high USDINR forwards, high INR real interest rates, stable macro, and an implicit RBI insurance against volatility is a powerful incentive for the $100B INR carry trade.

The current RBI forward and volatility intervention approach feeds a vicious loop that brings in more reversible USD inflows. Higher FX intervention comes at a cost (RBI pays the carry, after all), and lowers RBI’s dividend to the government. Higher intervention also risks Uncle Sam calling us out as currency manipulators. Given the size of our overall CAD, that charge should be laughable, except that we have a trade surplus of $20B with the USA, and Trump’s mercantile populism can trump logic. 

So what’s the relevance of all this to USDINR?

The proposition is simple. We have seen a sharp increase in the reversible INR carry flows, incentivized by a combination of stable macros, our monetary policy stance and the RBI FX intervention methodology. This explains why despite mildly worsening CAD, INR has strengthened against USD. 

RBI and the MPC do not have an explicit FX policy. It’s one thing to say that market forces determine the value of the INR. But that statement rings hollow, when MPC action and specific RBI intervention methodology makes them a huge FX market player – whether acknowledged as such or not.

INR is impacted by monetary policy and intervention methodology, and the choices that we make here should be conscious of this impact.

The Regulatory Perspective 

So what do past MPC statements say about the possible side effects of our monetary policy on INR positioning, capital flows and currency markets? Nothing. Absolutely nothing. 

Every statement has a customary paragraph about the external sector, but that stops well short of linking flows or currency markets to our policy or intervention framework. 

It’s inconceivable that the six economists on the MPC would disregard the impossible trinity. So what explains this silence?

Perhaps silence is inevitable given that our MPC mandate is flexible inflation targeting using interest rates. Maybe the MPC avoids any deviation from the mandate – keeping it simple, as it were. I find this argument hard to digest though. A doctor has a mandate to address the ailment of her patient. But if the treatment has side effects, she has to track them as well. Monetary policy is known to have side effects on currency and capital flows. Surely the possible impact on INR, financial stability and our economy merits some explicit discussion?

Alternatively, perhaps the trilemma is being sorted out judiciously in the background. After all, FPI debt limits are controlled. INR has strengthened over time. Perhaps these compromises on capital flows and currency stability represent the right choices to address the trilemma. If so, the MPC should explicitly addresses questions around INR carry positions, RBI’s intervention strategy, and clarify their views on implications of INR valuation on the economy, rather than leave these unstated. Monitoring short-term foreign currency debt as a proportion of FX reserves may not be enough. Sudden demand for USD can come from several other sources, including as hedges for long-term currency debt.

The current monetary policy framework has gained much international credibility, and acts as a watchdog over government and market behavior. However, as I have written previously (see 2), monetary and regulatory policy impacts or could impact several areas - including currency markets, employment, inflation and asset prices. We need better-researched understanding of these dynamics in our specific Indian context, so that policymakers can make informed choices.

References

11.  https://ananthindianmarkets.blogspot.in/2017/11/indias-fx-reserves-sources-observations.html

22.  https://ananthindianmarkets.blogspot.in/2017/12/the-monetary-policy-committee-and-dr.html