RBI and India’s Exchange Policy Framework

 (A version of this note appeared in Mint per the link below: )

https://www.livemint.com/industry/banking/why-rbi-urgently-needs-a-forex-policy-11620227308648.html 

India’s Exchange Policy Framework

Unlike monetary policy, which is conducted under the explicit mandate of inflation targeting, foreign exchange management is left to the discretion of the Reserve Bank of India (RBI). For many years now, RBI has maintained that it does not target any value of the Rupee and only steps in to control some unstated measure of currency volatility. However, the sheer magnitude and nature of RBI intervention leaves it as a substantial determinant of currency rates, irrespective of its stated policy or intent. 

 

The core of RBI’s intervention policy through fiscal year 2020-21 (FY21) was excellent. It acted as a volatility heat sink amidst massive foreign exchange inflows. It prevented excessive INR overvaluation that could have impeded India’s domestic output, employment, and prospects for Atmanirbhar Bharat. As a result, it built up a reserve buffer that will be invaluable through the trying times of Covid-19 and beyond.

 

However, aspects of the impossible trinity – the interplay between monetary policy, capital flows, and currency markets - need to be better debated. Interest rate differentials impact our currency markets and trade competitiveness. Likewise, excessive RBI forward market intervention can entail huge hidden costs, burden banks with redundant dollar assets, and foster speculative flows in currency markets. 

 

Finally, while calls on the RBI to somehow use its substantial FX reserves to fund India’s domestic investment make little sense, we could consider setting aside some of the funds towards securing strategic international resources.

In all, perhaps a more transparent and considered articulation of RBI’s thinking around foreign exchange management can instill better all-round clarity, credibility, and confidence, without compromising on any of RBI’s operational flexibility.

 

Currency Flows Through FY21

 

India received record durable inflows during FY21. Amidst a sharp drop in consumption and imports through Covid-19, India’s FY21 current account balance was a surplus of about USD 27 bn till February 2021. During that period, we received net Foreign Direct Investments (FDI) of USD 41 bn, and equity Foreign Portfolio Investments (FPI) of USD 36 bn. 

 

Despite these substantial USD 104 bn of durable foreign currency inflows, USD barely weakened by 2% against INR in nominal terms, from 75.30 in March 2020 to 73.90 in February 2021. This was even as the trade weighted global US Dollar Index (DXY) – a measure of USD strength against other currencies - dropped by 8.2% from 99.0 to 90.9.

 

This relative stability in USDINR was because the RBI stepped in to purchase an estimated USD 74 bn in spot markets and another USD 79 bn in forward markets.

 

Given the sheer scale of intervention and influence, RBI’s oft-repeated statement – that it does not target any level of USDINR, and that it intervenes only to reduce some unstated measure of volatility – underplays its considerable market impact. 

 

RBI’s Currency Consideration Set – Flows and Volatility

 

A legislated inflation targeting mandate sets some guardrails for the conduct of the Monetary Policy Committee (MPC). In contrast, there is no public framework that guides RBI’s foreign currency operations. We can only guess how RBI might decide on its foreign exchange operations.

 

For one, RBI likely would have considered whether the massive durable foreign currency inflows of FY21 was a one-off.  

 

Prior to FY21, with some fluctuations, India saw an average annual durable outflow of just USD 1 bn. The peak inflow before FY21 was USD 28.9 bn in FY17.

 

To that extent, the FY21 (till February) net durable inflow of over USD 104 bn appears to be a Covid-19 driven one-off, amidst a sharp drop in consumption and imports, and a surfeit of global liquidity.

 

If the RBI had allowed USDINR to ‘find its own level’ through FY21, USD could have spiralled to perhaps 68.00 or even lower against INR. 

 

Such a fall could well have sharply reversed, if and when durable flows reverted to more ‘normal’ levels. The ensuing volatility could have been debilitating for anyone involved in international trade and investments. 

 

Given this, RBI was fully justified in stepping in as a market heat sink. Of course, the price of USDINR at which such intervention should take place still remains an open question.

 

Real Effective Exchange Rate

 

One simplistic measure to judge the ‘appropriate’ value of a currency is the Real Effective Exchange Rate (REER). 

 

Here is how it broadly works. Assume that 1 USD is worth INR 75 today. Assume that the price of a widget today is USD 1 in the US, and INR 75 in India. Assume an annual inflation of 2% in the US, and 6% in India. After a year, therefore, the widget would be priced at USD 1.02 in the US, and INR 79.5 in India. If the value of USD remained at INR 75.00, we could import widgets from the US at INR 76.5 (USD 1.02 X 75.0) apiece, much cheaper than the INR 79.5 locally. Domestic producers of widgets would be unable to compete, at least till widget prices and currency rates rebalanced.

 

Admittedly, there are several additional factors that need to be considered, including the possibility and costs of cross border trade, the context around other commodities and currencies, and the choice of a starting point.

 

Nevertheless, the principle is useful, particularly as India embarks on ‘Atmanirbhar Bharat’ to raise domestic output and employment. Chart 1 below traces two trade-weighted REERs over time.

 

Source RBI, CEIC

 

Per the FY06 base year 36-country REER, INR was 17.1% overvalued as of January 2021. Per the FY16 base year 40-country REER, INR was 4.6% overvalued as of March 2021. 

 

With the caveat that the REER metric has limitations, this does suggest that the value INR should further weaken for us to remain competitive. 

 

Seen from this perspective, the RBI was fully justified in preventing excessive strengthening of the INR in FY21, and a worsening of our terms of trade.

 

Impossible Trinity – Investments that chase “Carry”

 

The ‘impossible trinity’ suggests that a country cannot simultaneously conduct independent monetary policy, remain open on the capital account, and have a stable currency. Beyond this textbook definition, we need a deeper appreciation of how this plays out in India.

 

For a while now, we have been guided by flexible inflation targeting in the conduct of our monetary policy. This framework is silent on the impossible trinity. The implicit assumption is that currency markets should be managed separately, while the MPC uses monetary policy to tackle inflation. However, interest rates can impact flows and currency markets more than they impact inflation. 

 

The chart below illustrates one particular aspect of how this can and does play out.  

 

Source: CEIC, RBI, Observatory Group, Investing.com

 

The black line denotes what we call the USD-INR “carry differential”. Here is how it works. 

 

Consider July 2017. US 10-year Treasury yields were then at 2.3%, while 10-year Indian government bonds were at 6.5%, yielding 4.2% more US treasuries. 

 

At the same time, US CPI inflation was at 1.7%, while India CPI inflation was at 2.4%, or just 0.7% higher. 

 

Indian bonds therefore yielded 4.2% more than US bonds, compared to the 0.7% inflation differential between the two countries. Adjusting for inflation, global investors could perceive a “carry differential” benefit of 3.5% (4.2% less 0.7%), in holding Indian bonds rather than US bonds.

 

Admittedly, many more factors such as inflation and currency expectations go into international investment decisions. That said, note that times during 2011-2018 that were characterised by worsening carry differentials largely saw outflows from FPI debt, while periods of improving carry differentials largely saw FPI debt inflows.

 

FY18 was a particularly notable year. During that year, India saw durable outflows of USD 16.7 bn across its current account balance, FDI and FPI equity investments.

 

Despite this, RBI net purchased USD 43.7 bn through FY18, and USD weakened against INR from 67.5 in January 2017 to 63.8 in December 2017. In REER terms, INR strengthened sharply from 101.6 in January 2017 to 107.6 in December 2017. 

 

This was because India saw reversible “carry” seeking inflows of USD 60 bn during FY18, comprising of FPI debt and similar inflows. Carry differentials fostered some large volatile, reversible inflows, and altered INR REER to levels that significantly weakened India’s terms of trade and export competitiveness.

The next year in FY19, much of these reversible flows moved out sharply, causing significant currency volatility. Interest rates had a significant role to play in this build-up, but little of this found any mention in the debates surrounding our MPC meetings. 

 

Impossible Trinity and Currency Forward Markets

 

Another manifestation of the impossible trinity involves the less-tracked currency forward markets. 

 

RBI’s spot purchases of foreign currency entail expansion of RBI’s balance sheet and infusion of INR banking liquidity. While such INR liquidity can be sterilized by reverse repos and MSS issuances, these involve visible costs to the RBI and government.

 

To get around all this, in FY21, RBI purchased USD 79 bn of USD in the forward markets rather than in spot markets.

 

However, there is no free lunch. Some of RBI’s forward purchases tantamount to it buying USD in spot markets, placing it back with banks, and instead borrowing INR from them. While INR banking liquidity injection was thus avoided, USD assets with our banking system rose from just INR 22,000 crores in March 2020 to INR 2.7 lakh crores in January 2021. 

 

Stakeholders (including RBI auditors, ironically) sometimes chide banks for carrying such large USD balances, which actually arise from RBI intervention. The banking system can only deploy these USD balances in overseas assets such as bonds and deposits, until the real economy absorbs them for imports or overseas investments. 

 

If USD assets of banks are frowned upon, they would have little choice but to pass the USD parcel amongst themselves, selling the USD now and buying it back in the forward markets. This in turn would spiral up USDINR forward rates and the implied INR interest rate in currency markets.

 

As this played out, through its FY21 forward purchases, RBI effectively borrowed 1-year INR through foreign currency markets at steep – but somewhat opaque - INR rates between 5.00% and 5.75%, against T-Bill yields of 3.75%. RBI’s added annual cost in using forwards rather than money markets to sterilize INR liquidity is estimated at INR 9,000 crores. 

 

In addition, higher forward premia invited speculative forward selling of USD. While durable flows in FY21 (till February) were at an estimated USD 104 bn, RBI itself purchased USD 153 bn across spot and forward markets. The balance USD 49 bn likely represents volatile carry-seeking inflows, particularly in offshore NDF currency markets. 

 

The recent volatility in currency markets is at least in part due to these gyrations in forward markets and from the actions of carry-seeking speculators.

 

Dollar, Dollar Everywhere?

 

We just discussed the higher USD balances with the banking system. What about the levels of FX reserves with RBI?

 

First, we must appreciate the immense value of these substantial buffers, as we battle through and beyond the Covid-19 pandemic. They provide us substantial degrees of currency and monetary policy freedom during these trying times.

 

Second, calls on the RBI to use these to fund India’s infrastructure investments make little sense. If the investments are in INR, the borrower would simply sell back the USD, and RBI’s currency reserves would likely be restored. On investments that entail imports of capital goods, are they only waiting for ‘cheap’ loans from the RBI?  If the argument is that RBI should step in to lend because banks and borrowers aren’t doing enough, that is a case of applying the wrong medicine to the right problem. 

 

Finally, we must still debate how RBI deploys its substantial reserves overseas. Little about RBI’s overseas investments is public. One presumes that these are into high quality short-term sovereign bonds and deposits.

 

This conservatism is welcome. Nevertheless, drawing from the experience of other jurisdictions, we could explore the possibility of setting up a specialised entity to manage a core part of the reserves, particularly to secure crucial international resources and assets.

 

Summary

 

As India battles through Covid-19 and beyond, the RBI will be called upon to provide monetary relief while sustaining external stability . Given the interlinkages, the two objectives can be in conflict. Thankfully, RBI has adroitly built a strong buffer of currency reserves to help navigate this. 

 

As with our monetary policy framework, a considered debate around RBI’s exchange management objectives, tools, interlinkages, and outcomes can help instil all-round clarity, credibility and confidence, without compromising on RBI’s operational flexibility.