This is the best time for companies with a natural hedge to actively manage it by covering imports at the spot and selling the equivalent amount of exports forward to 3-months
While the rupee is still holding tightly right above the Rs 73 level, the battle is joined. Core inflation remains high at 5.5%, and with the economy opening up quite nicely, we could see this threat continue.
Despite net inflows of over $2 bn in the week ending February 5, India’s foreign exchange reserves fell by a huge $4.88 bn. The last time reserves fell sharply—in March this year—foreign portfolio investment (FPI) flows were negative by a gigantic $7.8 bn.
Part of the decline in reserves was undoubtedly related to dollar strength during the reporting week. When the dollar is strong overseas, the USD value of EUR-denominated reserves falls. During the week, USD did strengthen but only by around 1%, so even if half the reserves were denominated in EUR (or other non-USD currencies), this would explain only about $2.5 bn of the decline. Clearly, something different is happening, and the needle points squarely at Reserve Bank of India’s forward intervention in the domestic market.
Since the start of the year, and then, of course, after the market-delighting budget, Reserve Bank of India has been working furiously to prevent strong inflows from pushing the rupee too much higher than 73. However, buying dollars at spot requires Reserve Bank of India to pump rupees into the market, which unbalances its efforts to keep liquidity and inflation under check. Thus, it has increasingly been intervening in the forward market—this involves entering into swap transactions with banks where RBI sells spot USD from its reserves and buys them back in 3-months, 6-months and so on.
The volumes are obviously significant from the fact that the forward premiums have been rising sharply—the 3-month has reached 6%, from an average of under 4% through all of 2020. While this enables better control of spot liquidity, depending on the amount of intervention, the banks themselves have to sell the dollars (that they bought from RBI in the swap) in the spot market, which explains the slow creep above 73 the past couple of weeks. With inflows are unlikely to weaken, the pressure on Reserve Bank of India remains intense. It has been forced to conduct swaps all along the forward curve out to (reportedly 5-years), and the slope of the forward curve has risen sharply—the difference between the 12-month and 3-month premium crossed 1% last week, a level not seen since 2008.
While the rupee is still holding tightly right above the Rs 73 level, the battle is joined. Core inflation remains high at 5.5%, and with the economy opening up quite nicely, we could see this threat continue. Thus, Reserve Bank of India will be hard-pressed to bring rates down, which would keep the foreign investors delighted; the swap game obviously has limits, so it is possible that RBI may not be able to hold the line too much longer.
But, of course, trying to judge when things will turn or what will turn them is a mug’s game.
To my mind, this is the best time for companies with a natural hedge to actively manage it by covering imports at the spot and selling the equivalent amount of exports forward to (say) 3 months. With 3-month premiums paying more than a rupee, every $10 mn of natural hedge would add Rs 1 cr to the bottom line, without any foreign exchange risk, since imports and exports would be logged at the same spot rate. There would, of course, be MTM (or opportunity) risk on the exports sold forward, but this is just a number; it isn’t real, like an extra Rs 1 per dollar. To quote Narayana Murthy from a long time ago, “Cash is real, profits are an opinion.”
Net importers should beware the temptation of riding the market too long without any railings. It is much better to set a rolling stop-loss, which both allows you to capture upside moves and protects against any sudden sharp decline. The trick is to set the stop loss at a sensible level, but the far more important trick is to follow the stop loss with discipline.