Curbs on Russia a chance for India to internationalise rupee

The current Ukraine-Russia conflict falls in the category of unknown known with crude prices going ballistic in the aftermath of war but now settling around $110/bl (barrel), and supposed to decline further. Interestingly, in the merchant market (in both spot and forward segment) there was an excess demand of $30.4 billion during Apr'21– Jan'22 (till 14th).

However, as per an internal economic research report by SBI, in the interbank market the trend is quite opposite and there has been excess supply of $11.6 billion in the same period (sans SWAP segment) and this must have increased significantly by now. Overall, merchant dollar demand was far higher than supply as they were already anticipating a stronger dollar and hence may have been holding to long position in dollars. This was being balanced by excess dollar supply in interbank market, but the net effect is a large demand of dollars at $18.8bn. The report believes a large part of this demand was counter balanced in the offshore market, imparting stability to the dollar rupee movement.

However, it goes on, with onset of global turbulence, the offshore market players have now also turned buyers of USD and this would have further pushed the rupee lower. In this context, one known unknown that might be made clearly known is publishing the data on offshore market rupee dollar transactions by RBI (currently not published) that would impart a lot of transparency and credibility in the market! By publishing the data, even with a lag, the RBI could actually move the market with it!

Meanwhile, the RBI has been active in the foreign exchange market and actively propping up the rupee. Simultaneously, with foreign exchange intervention of the RBI now a part of inflation targeting, the rupee has largely remained devoid of serrated volatility. This has worked favourably with rupee having an appreciating bias that has helped to contain the imported inflation in check. Additionally, such interventions creating liquidity is now also being managed by swaps to delay the liquidity impact of intervention. Intervention operations to manage volatility in the exchange rate typically pose challenges for monetary policy independence by influencing the term structure of interest rates.

Says SBI group's chief economic advisor, Saumya Kanti Ghosh, "In this context, we must mention that the RBI has also been using the Sell/Buy swap route effectively to provide liquidity, while smoothening the forward premia curve in the shorter tenor. An overwhelming proportion of net forward book of RBI (47 billion out of 49 billion approx.) stands maturing between three months to one year and more longer tenor swaps, along the lines of what we saw on March 8, for $5 billion that received nearly thrice the bids, and it should help extend the maturity, easing the liquidity concern as well as be tenor antagonistic."

With elevated crude oil prices, RBI's intervention in the FX market will reduce INR liquidity and hence does not require sterilisation operations through forwards. RBI may also choose to allow some forward positions to mature if INR depreciation continues. Driving out irrational market participants should anchor RBI's efforts to provide directions, sans much volatility, the report added.

RBI may look at intervening in the NDF market instead of the onshore market through banks during Indian time zone. This has the benefit of not impacting rupee liquidity. Also, majority of the USD buying in onshore market follows offshore market, either for view-based trades or arbitrage. Directly intervening in the NDF market will reverse the arbitrage. Dollar has gained strength against all EM (emerging market) currencies, including rupee, with Fed hinting in no uncertain terms its sticking the course for rate enhancements going forward, even as it battles inflation and unknots the balance sheet lest it inherits a balloon syndrome. US inflation is now close to 8 per cent, the highest since Jimmy Carter was the President. Crude is already in a precarious zone, though it has declined lately as there are signs of a thaw in the Ukraine and Russia conflict. On the downside, crude sticking above $100 level for next few months along with hurtling commodity prices could be the Damocles sword for EMs.

USD/INR is a mean-reverting currency pair. Analysing the 6-month and 12-month moving average as the two means, the period since financial crisis may be divided into seven time zones. Over the past few years, USD/INR has formed a bottom in between these two averages except few episodes to deviate due to stained global risk-off. However, the good thing is that even assuming that the Russian-Ukraine conflict would drag on for now, the report expect the USD/INR, the most tracked pair in local FX market, to trade in an elevated zone, but ideally, the FY23 average should not be higher than 76-78, with an appreciating bias. During the global financial crisis, the rupee had continued to decline and lost around 13 per cent during Jan'2008 to Jul'2011. However, in the post crisis period, the volatility had become significant (4.6 per cent) and INR declined by 41 per cent during Jul'2011 to Nov'2013. However, the recent episodes of rupee volatility has been much less and lower forex volatility in India (USD/INR volatility movement in the range of 1-2 per cent) have diminished the depreciation risks, and hence we expect rupee not to be majorly impacted.

However, as a matter of fact, one should not rule out episodic currents of volatility in local currency against the USD in case of further negative geopolitical surprises.

An interesting anecdote, the hegemony of USD appears likely to continue in next few decades, notwithstanding the alternate settlement mechanism being envisaged by select nations desirous of continuing inter-territorial trades of compulsory nature, circuiting around the western sanctions as backdoor talks gather momentum for rupee-rouble or yuan-rouble settlements globally, with some enthusiasts betting for gold settlements too! This, however should present the moment of reckoning for the internationalisation of rupee too, underpinning the need to evolve alternate payment and settlement mechanisms.