Losing currency: Rupee sinks as monetary policy triggers carry unwinding

In a sign that the Reserve Bank of India’s (RBI’s) loose monetary policy could be leading to unintended consequences, the rupee nosedived 1.52 per cent after the central bank committed to buying Rs 1 trillion bonds from the secondary markets in the first quarter.
 
The rupee closed at 74.56 to a dollar — the lowest since November 13, 2020. The intraday fall is the steepest since the August 2019 levels.
 
According to Paresh Nayar, head of forex and fixed income at First Rand Bank, there was sustained dollar demand since Tuesday, which increased on Wednesday.
 
That may have triggered some stop-loss positions, leading to a sell-off in both offshore and onshore markets. Seeing the rupee fall sharply, foreign investors — who had not hedged their exposure — may have had to cut their position, further exacerbating the situation. Currency dealers also say Wednesday’s simultaneous movement in both offshore and onshore markets indicates massive unwinding in the carry positions.
 
Carry trade gets built when investors borrow from a cheap source, like the US where rates are low, and invest in a country where yields are higher, such as in India. The currency risk, in turn, depends on the inflation differential between developed and emerging markets (EMs). The spread has remained wide in recent times due to relatively higher retail inflation in India, which reflected in higher domestic yields. 

 
However, in the past six months, bond yields in India have increased at a much slower pace than in the US. The yield on 10-year Government of India bond is up just 32 basis points (bps), from record lows hit in August last year. In comparison, bond yields on 10-year US government bond are up 113 bps, or 1.13 percentage points, from their record lows.
 
This has tightened the spread between the yield on 10-year India government bond and US 10-year government bond. The yield spread is now down to 4.42 per cent, from 5.76 per cent in April last year, and the three-year average of 4.9 per cent.
 
Ananth Narayan, senior India analyst, Observatory Group, estimated the size of the carry position to have widened to $40 billion by end-February. 
 
This can technically continue for a long time, and is no reason for such sharp movement, but “in this case, we probably got caught in the perfect mini-storm — heavy positioning amid nervous fundamentals (the second wave of infections/India’s growing import bill), and an RBI that would be well aware of this growing positioning, and likely even happy with a shake-out (with a welcome correction in the rupee to market complacency)”, said Narayan. 
 
The 10-year bond yields fell as low as 6.06 per cent after the monetary policy. If the RBI has to help the government borrow Rs 12.05 trillion, it will have to keep the yields low.
 
“The RBI’s action is diverging with its EM peer central banks like Turkey, Russia, and Brazil. Hence, participants may have started unwinding prolonged rich carry trade in the rupee,” said Amit Pabari, managing director, CR Forex Advisors.
 
Economic theory suggests that in a free-floating exchange rate system, the policymaker can either target the exchange rate of their currency, or can control the interest rate. They can’t control both the variables at the same time. Since the RBI is trying to bring down yields, the exchange rate, or the portfolio flows, could get impacted.
 
For example, Turkey tried to keep interest rates low on government orders, resulting in a sharp depreciation in the lira.