Repeating the 2013 formula may not be a bad idea
Despite the $4 billion of outflows from the equity and bond markets in January and February following the Fed’s rate hike in December—and the likelihood of more hikes in 2016—the subsequent $2.5 billion of inflows in March has seen the rupee regain a lot of lost ground, restoring it to levels of 66.63 to the dollar, as a result of which it has out-performed most of its peers. Not surprisingly, the country’s reserves are at a record high of $355 billion, putting it in a position to better defend the currency. It would, however, be premature to think all is well as global markets remain volatile. While the Fed has indicated a pause in the face of a weaker economy—Q4 growth in the US was a mere 1.4%—investors could once again start moving out as rates go up. It could also go the other way if the US slows rate-increases and investors agree to take on more risk as seems to be the case right now—in a scenario where oil is trading where it is, though, it is difficult to see investors wanting to take on too much more risk
The large forex outflows—due to global volatility—also had other important side effects since it accentuated the liquidity shortage in the economy. The impact could have been ameliorated had the Reserve Bank of India not delayed in intervening via open market operations (OMOs), but for whatever reasons, it didn’t—possibly, it expected forex flows to restart sooner. The shortage of liquidity, in turn, played a big role in impeding the transmission of rate cuts by the central bank. After all, when the benchmark is close to 8%, it is hard for the rates in the system to come down. Bank of America’s India economist Indranil Sengupta estimates the liquidity deficit by the end of March could end up higher than it was last year when it was R1.12 lakh crore. Apart from RBI needing to keep the OMOs coming for this reason, forex flows could once again get volatile if a large enough chunk of the FCNR deposits that are due in September get redeemed. Even if half the $27 billion of deposits, which were mopped up in late 2013, are pulled out, it would create a shortage in the money market, apart from weakening the rupee significantly.
Which is why, RBI may want to facilitate a rollover of a portion of these deposits by, as it did in 2013, bearing a part of the hedging costs. In 2013, banks were allowed to swap freshly-raised dollars, with a minimum maturity of three years with RBI at 3.5% which brought down the cost to 7.5%. However, that would be a price worth paying since global currency markets are going to be volatile with various central banks trying to adjust their currencies in order to cope with lower growth and the fall in global trade. Moreover, it would also ease pressure on liquidity; else banks might again need to raise interest rates on deposits. It seems a win-win since the last thing RBI wants is either more currency volatility or tightening of liquidity.