First, a little trivia. The demand for the dollar in the forward market always acts as a leading indicator of an exchange rate crisis. Subsequently, the slide in the rupee value beginning August 2011 was waiting to happen with the demand for dollars in the forward market beginning to build up in both the merchant segment and interbank segment from June 2011 onwards (see table). For example, the excess demand for dollars in the merchant segment of the forward market crossed $11 billion in September 2011 from $429 million in June 2011, only to decline to $9.5 billion in January 2012 on the back of RBI currency supportive measures.
How do we explain this excess demand in the forward market Simply, in an environment of rupee depreciation, the exporters typically adopt a wait-and-watch attitude with regard to bringing in export proceeds from abroad. This pushes down the supply of forward dollars. On the other hand, the forward demand for dollars is magnified during times of forex market crises in both the merchant and interbank segment. In the merchant segment, the demand is because of a rush by importers and the like to cover unhedged positions (excess demand for forward dollars crossed a staggering $11 billion in September 2011 from a negative $429 million in June 2011). In the interbank segment, the mad rush is because banks typically go long on forward dollars with the idea of making profits (from $3.53 billion in June 2011 to $5.7 billion in September 2011).
Clearly, the speculation by market players under the current circumstances only hastened the fall in rupee value. This situation has also been aggravated at times by extraneous factors, like payment for Irans oil bill and defense purchases being made from the domestic markets and perhaps resulting in market players scrambling for forward cover of their dollar liabilities on the expectation that the demand supply gap may worsen further.
Now, the masterstroke by RBI. As Exposition 1 shows, RBI smartly changed track and intervened in the forward foreign exchange market in November 2011 after a gap of 12 months. Even though there is an enormous amount of economic literature on spot market interventions by central banks, there is little on forward markets. One possible reason for this could be that the forward market interventions (typically swap transactions, buy-sell or sell-buy swaps, outright forward purchase/sales) are typically construed as an example of secret interventions; that there are no official reports of intervention, even though the central bank indeed intervened.
Interestingly, in the 1950s and early 1960s, there was considerable debate on the efficacy of the forward exchange market initiated by John Sparos, which is still relevant today. Going by John Sparos, the best way to fight currency speculation is to deliberately let the forward premia rise to unreasonable levels and thereby penalise the currency speculators as their exchange rate expectations about a depreciating domestic currency are belied. Alternatively, if there is a depreciation of the domestic currency in the spot and the forward market, then the authorities must sell the foreign currency in the spot market (that is leaning against the wind), whereas the authorities must deliberately purchase the foreign currency in the forward market (leaning with the wind) in order to penalise the speculative players in the forward exchange market. We call this policy in the forward exchange market the Sparos effect, and it is precisely the Sparos effect that turned the tide for the rupee. This is how it did it.
Consider Exposition 2. RBI was a net seller to the extent of $1.62 billion in the forward market in November 2011. We believe a part (possibly significant) of this forward sale was perhaps a sell-buy swap (selling spot dollars in exchange for domestic rupee resources and buying them forward). This is because RBI may have avoided outright forward market purchases, given that the central bank may avoid draw-down of foreign exchange reserves (faced with the the prospect of a strain on the same by June 2012). As the figures for November 2011 shows, the gross sale of forward dollars was $1.62 billion during the month. Since there was a significant increase in forward premia (across all spectrum) in November 2011, it is clear that such a transaction was primarily a sell-buy swap. Most importantly, such sell-buy swaps worked, as they immediately pushed up the forward premia in November 2011, leading to rupee appreciation in subsequent months.
Clearly, the RBI strategy has worked in this case. The advantage of these swaps is that they merely change the composition of foreign change reserves and hence are another way of sterilising capital inflows. However, there are disadvantages, too. If the foreign exchange market is fairly thin, the use of foreign currency swaps for sterilisation only adds volatility to the forward market. Interestingly, as RBI puts it, forward sell-buy swaps, even when undertaken on a large scale, do not have lasting impacts in correcting distortions in forward premia. Also, the cost of swaps, as captured in the accounts of RBI, has increased with the appreciation of the rupee. In the end, even after acknowledging the limitations of swap transactions, they have worked, with portfolio and export proceeds picking up enough steam post November 2011 (see exposition 2).
This, perhaps, has been the most significant gain in 2012! However, a word of caution. Any sell-buy swap when it unwinds will be followed by forward transactions to neutralise the former (in December 2011, the official data shows that there were $250 million forward purchases), and subsequently, there may be an increase in the volatility in rupee. As Exposition 3 suggests, the volatility in the rupee value, which declined significantly from end-Dec ember 2011 has started to increase again, that portends bad for the market.
Finally, as the data suggests, there has been a liquidity withdrawal of nearly R55,000 crore during November-December 2011, because of foreign exchange market interventions. This perhaps sets the perfect recipe for another round of CRR cuts in March 2012, to offset such a negative impact.
Soumya Kanti Ghosh is director-Economics & Research, FICCI. Views are personal