IMAGE VIA MONEY CONTROL
THE RESERVE BANK of India has some $688bn in foreign-exchange reserves. That is enough firepower to buy every single rupee in circulation outside the banking system twice over. Yet faced with the steepest currency slide in Asia this year, the central bank chose not to sell dollars. Instead it tightened regulations on the arcane plumbing of the derivatives market. Recently the RBI told banks they could no longer offer non-deliverable derivatives (contracts where people bet on a currency’s future value) on the rupee. The currency jumped against the dollar. Traders got the message: betting against Mumbai is becoming a nightmare.
The rupee’s decline has been triggered by the war involving America, Israel and Iran. Oil prices have spiked. For India, which imports over 80% of its crude, that is a punch to the solar plexus. Its trade deficit is now expected to average $34bn a month, according to Abbas Keshvani of RBC, a financial institution. That means a grinding demand for dollars. Foreign portfolio investors, spooked by the geopolitics, pulled nearly $12bn out of Indian equities in March alone. Remittances from the 10m Indian workers in the Gulf—a $51bn annual cushion—have stuttered as flights are grounded and shipping lanes through the Strait of Hormuz freeze up. Dilip Parmar of HDFC Securities, a broker, tells the Financial Times that dollar supply “has completely stopped.”
Central banks usually respond to such pressure by selling dollars from their reserves to buy rupees. The RBI has done some of that. Reserves are down some $40bn in a month. But the pace of outright intervention seems restrained. The reason is the central bank’s forward book. Analysts at Nomura, a bank, estimate that the RBI’s net short position in the forwards market—a promise to deliver dollars later rather than now—has ballooned to perhaps $100bn. Heavy spot-market intervention now would push those off-balance-sheet liabilities into the harsh light of the reserves tally. Better, it seems, to make the market so uncomfortable that speculators flee of their own accord.
The two moves this week are meant to break the feedback loop between the onshore and offshore markets. On April 6th the RBI capped banks’ open positions in the deliverable market at $100m. When traders shifted their bearish bets to the non-deliverable forwards market—where contracts are settled in dollars in global financial centres rather than rupees in Mumbai—the RBI followed them there, banning the product entirely. The offshore trade in rupee derivatives is huge; Dhiraj Nim of ANZ Research, a research firm, pegs the daily volume at $140bn to $150bn. By severing this link, the RBI hopes to stop offshore pessimism from poisoning the onshore price.
This is a classic emerging-market gambit: use capital controls to buy time and protect the war chest. But it comes at a cost. The market does not vanish: it just becomes less transparent and more expensive. As one analyst notes: tighter rules can lead to “thinner liquidity, wider bid-ask spreads, and a greater role for offshore markets in price discovery”. The RBI wants to see what the rupee is worth without speculators muddying the water. The risk is that it ends up seeing only a reflection of its own restrictions.
The political economy here is sticky. Arvind Subramanian, a former chief economic adviser, points out that no Indian politician wants to see the currency in freefall. A weak rupee is equated, perhaps foolishly, with national weakness. Meanwhile big corporate borrowers who have gorged on dollar debt prefer a strong rupee to keep their repayment costs down. The exporting lobby, which would cheer a cheaper currency, is diffuse and poorly funded. The bias is always towards propping things up.
Governor Sanjay Malhotra says the curbs are temporary and that reserves remain “sufficient”. He may be right on the reserves. But the war has exposed an awkward truth about the RBI’s management of the rupee over the past decade. It spent years accumulating a vast arsenal by buying dollars to prevent the rupee from appreciating too much. Now when the textbook says to let that arsenal do its job and absorb the shock of a weaker currency, the central bank is reaching for the administrative toolbox instead. The mountain of cash was built for a rainy day. It appears to be pouring but the umbrella is up. ■
