Rupee strength: Decoding Reserve Bank of India’s forex policy shifts

September 19, 2020 7:00 AM

RBI will likely buy $8 billion more by March 2021 to build on the return to sufficient FX reserves after 10 years. It can easily sell $50 billion to protect the rupee

The lenders are best placed to assess the requirements of its customers, the RBI said, toeing the line taken by the government in this regard.

By Indranil Sen Gupta & Aastha Gudwani

What’s changing in RBI’s FX policy, we have been asked, with 2.7% appreciation of the rupee since July? We think RBI will buy FX less aggressively than in the past, having achieved adequate FX reserves (we estimate $500+billion) again. Second, it has stated that appreciation helps cool high CPI inflation, although we find ‘imported’ inflation relatively weak. Finally, RBI will likely allow the rupee to weaken if the dollar strengthens, as it can sell up to $50 billion to fend off any speculative attack on the rupee. That said, we continue to expect RBI Governor Shaktikanta Das to consolidate the return to adequate FX reserves.

RBI has actually picked up $24.3 billion from July to the week-ending September 11. Our BoP estimates suggest that it can buy $7.6 billion more by March 2021.

On balance, we expect RBI to continue with its asymmetrical FX policy, of buying FX when the dollar weakens and letting the rupee depreciate when it strengthens. As inflation peaks off, we think that there still will be a policy bias towards a weak rupee till growth revives. Our FX strategists see the rupee at 74 to the dollar by December with the dollar at 1.14 to the euro.


RBI to buy FX less aggressively…

RBI is likely to be more relaxed about buying FX than before as it has achieved sufficient FX reserves. Stronger rupee will cut ‘imported’ inflation. Although imported inflationary pressures are relatively weak, in our view, RBI will not prevent depreciation if dollar strengthens. We think that the RBI will be keen to see depreciation if the dollar strengthens as we expect. Given that it can sell up to $50 billion to fend off any speculative attacks, it can easily effect orderly depreciation.

… but still continue to build up FX reserves

Should RBI be buying FX with reserves at $542 billion? Higher FX reserves will likely comfort FPIs into putting more money in India (up $6.5 billion FYTD), quite like it was in 2004-08.

Second, they are India’s only defence against contagion risks with G-3 central banks running out of ammunition. Finally, dollar risks are likely overdone. In our view, high FX reserves ensure:

Stable rupee: Large depreciation in global shocks, are now likely to be a thing of the past;
Higher FPI flows as high FX reserves cut exchange rate risks;
and Cheaper FX loans: Corporates should be able to get FX cheaper as markets normalise.

RBI to buy $8 billion by March; $23 billion 2Q20 CAS

Our BoP estimates continue to suggest that RBI can buy $45 billion of FX ($37.4 billion FYTD) in FY21, with our oil forecast of $43.7/bbl and $7 billion of FPI inflows (BofAe). We expect the June quarter to post a massive current account surplus of $23 billion. With M3 growth returning to excess supply, we still expect RBI to buy FX forward to limit rupee liquidity. That said, the trade deficit in August worsened to $6.8 billion from $4.8billion in July.
Higher gold imports and deepening non-oil export de-growth more than offset the 29% decline in non-oil, non-gold imports in August. Even so, the FYTD trade deficit is a bare $20.7 billion, well below $73.2 billion seen during April-August 2019.

Authors are India economists, BofA Securities
Views are personal

Edited excerpts from BofA
Securities India Economic Watch report dated September 16, 2020

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