Rupee strength may swell FPI investment into debt

The coming weeks may witness the continuation of the rupee’s strength against the US dollar and therefore, a challenge for the Reserve Bank of India (RBI) to manage the liquidity and external value of the Indian currency. The risk to the above premise is the early contraction of the US Federal Reserve’s balance-sheet and consequent dollar reverse flows.

A string of reasons for this are the following — the forex reserves of India are at $375.7 billion, as per RBI’s latest statistics. These have increased during the week ended May 5 over the previous week by nearly $3 billion. The build-up of forex reserves, at present at an all-time high level, is equivalent to nearly 11 months of India ‘s import requirements, as against an International Monetary Fund-recommended safe level of six months’ imports.

The sharp increase of $5.8 billion in the past five weeks since March end is partly attributed to the weakness of dollar against other major currencies, in which a part of our forex reserves are held. But the major part of the increase is a result of continuous intervention of RBI in forex markets to absorb the additional supply of foreign currencies (FC), due to capital flows brought in by the foreign portfolio investors (FPIs) and foreign direct investors (FDIs).

The intervention in forex markets by RBI affects system liquidity. RBI’s purchase of FC has thus resulted in further augmentation of rupee liquidity in Indian markets. The anaemic credit growth at 4.3% against a moderate deposit growth of 10.3% as at the end of April, poses a usual challenge for RBI akin to any other central bank to manage the impossible trinity of free capital flows, the domestic currency’s external value and independent monetary policy.

Globally, the dollar index has has fallen from 103 to 99.84 in the first four months of CY2017.

The Fed is holding securities for $4.5 trillion and has suggested contraction of its balance-sheet. This would be possible by not investing securities’ maturity proceeds held presently. It would directly impact global dollar liquidity conditions, possibly pressurising US banks’ deposit growth.

The recent consumer price index (CPI) reading for April has undershot market expectations at below 3% annual inflation level. This leaves the inflation differential between India and the US at less than 1.5%, while interest rate differential for policy rates stands at more than 5%. Unless other macroeconomic indicators for India deteriorate materially, this presents an opportunity for FPIs to invest more in Indian debt instruments, subject to the available limits.

MANAGING LIQUIDITY

• The intervention in forex markets by RBI affects liquidity of the system
   
• RBI’s purchase of foreign currency has further swelled liquidity of rupee

The writer is executive director, Federal Bank