Cometh the hour, cometh the idea. This phrase is apt for the latest USD-INR swap auction conducted by the Reserve Bank of India. The runaway success of the auction — with banks bidding for $16.31 billion against $5 billion that the central bank proposed to buy — shows that the tool was well-crafted, in a manner that benefits all stakeholders.

Besides obvious benefits such as providing liquidity, such an auction also helps signal the RBI’s intent that it will not allow a runaway appreciation in the rupee.

With the Indian currency doing a volte face in its performance, becoming one of the best performing emerging market currencies this year, from being among the worst performing, the central bank has been quite busy trying to control undue volatility in the rupee.

The rupee is likely to vie for the RBI’s attention for the rest of 2019 too, given that many of its drivers are now turning positive.

The swap

The RBI’s primary intention in using the forex swap was to inject liquidity in the system ahead of the elections and financial year-end, without resorting to further open market operations that tend to impact market interest rates. The ₹34,561 crore that the RBI plans to inject into the system could also boost consumption ahead of the election, thus keeping sentiment upbeat.

Banks seem to have lapped-up the offer because they can currently borrow dollars at a lower rate from international market and thus stand to gain by lending the dollars to the RBI at around 3.8 per cent annual return.

The weighted average premium of ₹7.91 for the bids was quite close to the three-year forward premium in the forex market. The immediate benefit of the swap has been lower hedging costs.

The swap, however, will not have a direct impact on the rupee spot rate; it only impacts the forward premium. But the move will help signal to the forex market that the RBI is scanning its arsenal to find innovative solutions to current issues, which include reining in the rupee.

The rupee strengthens

The rupee lost 8.9 per cent in 2018, led by increasing crude oil prices and rapid foreign portfolio outflows, only to reverse sharply higher to gain 1.9 per cent in the first quarter of 2019.

Sharp rupee depreciation may cause a furore among economists, but it does not put undue pressure on the Centre to take action.

This is because many companies have a natural hedge against their imports through their exports and the common man impacted by costlier imports does not have any voice.

But an appreciating rupee is greeted with a far less tolerant attitude. The exporters, who have a strong lobby, believe that the rupee needs to keep depreciating in order to make their goods competitive in overseas markets.

The recent strengthening of the rupee made the central bank intervene actively in the forex market to curb the rise. This is borne by the forex reserves increasing since the beginning of this calendar, to hit $405 billion recently.

What’s changed for the rupee?

The downward pressure on the USD-INR exchange rate eased since last September, when the rupee hit a low of 74 against the greenback. There seem to be some medium-term shifts in the drivers of the rupee that need to be taken note of.

The dollar rally, that pressured the rupee, appears to have ended. The dollar index rallied from 89 in March 2018 to 97 by December 2018, fuelled by the Federal Reserve’s aggressive interest rate hikes — four in 2018 with guidance for another three in 2019.

But the sharp sell-off in US equity market towards the end of 2018 coupled with threat of economic slowdown has made the Federal Reserve pause its rate hikes and adopt a more dovish stance. With expectations of the Fed staying on hold until June, the dollar index has cooled a little, to 96 levels.

The spectre of a slowdown in global growth has also been haunting other central banks. The ECB and the Bank of England too have decided to maintain a more benign monetary policy. As monetary conditions have eased in global markets, foreign portfolio flows into emerging markets, including India, have picked up.

The Indian equity market has received $6.3 billion of net inflows so far in 2019, a sharp contrast to net outflows worth $4.3 billion in 2018. Indian debt market flows have also turned slightly positive after witnessing outflows worth $6.9 billion in 2018.

Another factor that needs to be noted is that the rupee typically performs better in periods when global growth slows. Between June 2010 and 2011, as global growth fell from 5.7 to 4.3 per cent, the rupee appreciated from 46.44 to 44.6 against the dollar. Similarly, between December 2006 and March 2008, global growth declined from 4.9 per cent to 3.03 per cent, but the rupee strengthened from 44.2 to 40.1.

But once the global slowdown gathers pace, the rupee too begins declining; probably due to FPIs pulling out money and the adverse impact on exporters.

The IMF’s global growth and trade numbers have been on a downward trajectory since 2017. Since slowing global demand brings down commodity prices, India stands to benefit as it is a net importer. The Thompson Reuters commodity index is down from the recent peak of 200 recorded in June 2018 to 184 currently. This is conducive for our trade deficit.

Given the increasing possibility of a chaotic Brexit and a long drawn US-China trade war, central banks could be more cautious with their monetary tightening in the immediate future, thus keeping foreign flows strong.

The global slowdown is also likely to prolong, thus keeping commodity prices soft. The RBI could continue to mop up the incoming dollars to build its reserves. Besides this, it might also have to pull some other tricks out of its hat, akin to the dollar-rupee swap.

Related Topics