The Art and Science of Central Bank Currency Intervention

Intervention act to address dilution of structural woes

In the Indian context given the huge Current Account Deficit, RBI has to do a balancing act to keep Rupee exchange rate attractive to exports (and NRI inflows) and ensure price stability to attract long term foreign currency inflows. It is also important to ensure that exchange rate stay resistive to import of non-essential consumable items, and avoid provision of cheap dollars to hot-money exit and cheap Rupees on fair-weather entry.

RBI is seen adhering to these basic principles. But given the excessive, lumpy and sudden FII mood-swings, USD/INR exchange rate has witnessed sudden bouts of excessive volatility before normalisation. The recent Rupee weakness from 63-63.35 to 66.60-66.85 is also from the FII trigger, so is the appreciation from 66.85 to 65.60-65.85. Given the fact that RBI intervention during these times is with intent to speed-break momentum (rather than being beneficial to FII exit or entry), stakeholders need to stay caution on exchange rate risk on their balance sheet from exports, imports, foreign currency borrowings or investments.

Intervention theme to stay in support for exporters and foreign direct inflows

It is hard reality that there is no long term comfort on sustainability of the CAD at 1-2% of GDP and CPI inflation around mid-point of 2-6% tolerance zone. More so, when the benefit is largely from external cues over which India has no control. The risk in play are from Brent Crude recovery from long term base of $35-50 into $70-85; this 75-100% swing can push the CAD back to 3-5% if not backed by accelerated exports. If Rupee goes into excessive weakness along with Brent price recovery, CPI will be at risk of overshoot beyond 6% if domestic supply side capacity is not scaled up. All combined, it is kind of between the devil and deep sea situation. There is need to cut Rupee over-valuation (to support exports and NRI/FDI inflows), but can't go cheap to exert pressure on the CPI. In this context, it is not an easy task for RBI to do the balancing act to keep Rupee exchange rate around fair-value against the sudden burst of FII outflows and flood of FII inflows.

What's RBI intervention strategy?

RBI is seen to have 2-type strategy; operation of currency-peg when FII play is neutral, while allowing Rupee to find its own "floor" and "cap" on one-way FII flows from core stakeholders hedge strategy. What is the issue then? During normal times, the administration of particular range in alignment with adjustment of time value gives importers the comfort of staying unhedged to avoid paying time value, while exporters stretch their cover to encash time value. When Rupee gets into appreciation mode thereafter (from FII inflows), there is no regret for all. But, when it goes on the other side (from sudden burst of FII outflow), importers get caught on the wrong-foot and exporters in pain on the opportunity loss (and mark to market impact on the export contracts). This sets up "importer's fear and exporter's greed" syndrome adding momentum to one-way Rupee weakness (from importer hedge and exporter unwind). This kind of scenario is common in India Foreign Exchange market. More recently is the sudden value adjustment from 58.35/63.35 to 66.85 post the 68.85 to 58.35 Rupee rally between August 2013 to May 2014. While it is not major P&L hit on long term foreign currency liabilities/assets, it is severe damage on short term unhedged liability exposures.

RBI has no resolution to these stakeholders behaviour except to urge them not to take market risks for granted and to align the risk with on-balance sheet reward with appropriate Risk Managment policies and execution strategies. The philosophy is to avoid real bottom-line P&L hit, unmindful of opportunity losses if any.

What Next?

RBI range administration zone is now sighted at 65.60/65.85-66.60/66.85. In the event of lumpy supply from FIIs, RBI will be happy to allow Rupee appreciation to 65-65.35 looking for $ bids from importers. Can RBI allow Rupee appreciation beyond 65, which could hurt export growth? Doubt it against recent devaluation in EM currencies. If FIIs choose to exit (seeing limited juice in India risk-on assets against significant downside risks in the short term), RBI may allow the Rupee to set its own "floor" from exporters $ supply, building risk of revisit to 66.60-66.85, and beyond into 66.85/67.10-68.60/68.85 if DXY extends gain into 96.50-100.50.

Moses Harding