RBI's rupee defence comes at a cost as liquidity dries up, yields rise

By Pratigya Vajpayee and Subhadip Sircar

The rupee’s rebound from near a record low, after the Reserve Bank of India mounted its most aggressive defense of the currency since 2013, has bought the currency some time but at a steep cost.

The RBI has sought to curb speculative dollar demand and steer oil companies’ purchases away from the spot market. But in doing so, it has also suppressed some of the trading and hedging that normally help markets absorb currency shocks. More importantly, those measures don’t address the forces driving the rupee’s weakness: high oil prices, sticky inflation and capital outflows.

Liquidity in parts of the foreign-exchange market has dried up, hedging costs have jumped and bond yields surged. And yet despite the RBI’s efforts, few investors believe the rupee’s long-term downward trajectory has changed.

“Without a more fundamental improvement in inflation, real yields or the broader macro-outlook, we expect these pressures to eventually reassert themselves,” said Aaron Hurd, senior portfolio manager for currency at State Street Investment Management.

He sees the rupee weakening toward 99-100 per dollar over the next year, from around 95 now. Still, Hurd said much of that depreciation is already priced into the forward market, leaving him neutral at current levels. “We would neither buy the currency nor aggressively sell it,” he said.

The rupee has gained 1.8 per cent this week, set for its best run since April and making it the region’s top performer. Just before the RBI’s latest measures, the currency was sliding toward 97 per dollar despite a $133 billion diaspora deposit program and the central bank’s first rate hike in nearly four years, fueling concern that a break past that level could accelerate losses toward 100.

But the rebound in spot hasn’t erased expectations of further weakness. Importers and banks are still seeking protection against a weaker rupee over the coming months, pushing up demand for dollars in the forwards market. Hedging costs have climbed to their highest since 2016.

The forwards market has become “extremely dislocated,” said Abhishek Goenka, chief executive officer of IFA Global, a forex advisory firm. He said short-term forward premiums have surged, creating unusual pricing that makes it cheaper for companies to borrow rupees and swap them into dollars than to borrow the US currency directly.

At the same time, volumes and activity have come off significantly, Goenka said, advising clients to cover only their immediate exposures.

Bonds have also taken a hit, with yields climbing to more than a three-year high. Elevated oil prices and persistent foreign outflows are fueling bets that the RBI will have to rely more on rate hikes as currency intervention alone struggles to contain pressure on the rupee.

‘Swallow Poison’

Banks are bracing for fallout. Treasury desks will likely see subdued client foreign-exchange business and potential losses on their fixed-income trading books in the October-December quarter, said Anshul Chandak, head of treasury at RBL Bank.

“We will have to swallow poison for long-term gain,” Chandak said, adding that monetary measures need to be complemented by fiscal reforms to attract more foreign capital.

The market strains have led banks to raise concerns with the RBI that the curbs were draining liquidity and sought guidance on how broadly they applied. Late Thursday, the central bank clarified that the measures apply to derivatives used to hedge foreign-exchange risk, not to banks’ market-making activity.

There’s a risk that if liquidity stays thin and hedging remains expensive, companies and investors will demand greater compensation for holding rupee assets, or become reluctant to add exposure. That could leave the currency more vulnerable once the RBI scales back its support.

Repeated intervention by the RBI will be watched closely because predictability matters to investors, according to Shamaila Khan, head of global emerging markets and Asia Pacific fixed income at UBS Asset Management.

“The key is maintaining a transparent framework and efficient ability to hedge and transact,” Khan said. The measures haven’t materially changed UBS’s strategic view or allocation to India, but higher hedging costs will raise the returns it requires from Indian assets, she added.

For now, the RBI’s resolve should help cap dollar-rupee at around 96, according to Guan Yi Low, head of Asia fixed income at M&G Investments. Government bond yields remain attractive relative, but further buying is unlikely until liquidity conditions stabilise or the rupee’s outlook improves, she said.

“We agree that the INR’s recent underperformance is excessive,” Low said. “However, a reversal looks difficult until global oil prices stabilise and India’s capital account flows improve beyond temporary measures.”