Why a torrent of foreign funds threatens India's tight grip on the rupee

There's growing consensus among traders and fund managers that the mounting pressures -- particularly the liquidity glut distorting money markets -- may spur the central bank to consider changes

A relentless torrent of funds rushing into India’s markets may tip the central bank’s delicate balancing act in 2021.

For most of this year, the Reserve Bank of India has capped currency gains as global investors poured around $50 billion into stocks and stakes in companies. This has boosted rupee liquidity in a banking system that’s already flush with cash from the RBI’s stimulus measures.

There’s growing consensus among traders and fund managers that the mounting pressures -- particularly the liquidity glut distorting money markets -- may spur the central bank to consider a range of changes, from relaxing its grip on Asia’s worst-performing currency to curtailing bond purchases.

A modest gain in the rupee over the past month could mean that policy makers are already dialing intervention down a touch, or that inflows are starting to get the better of them.

“We believe that the RBI is facing a tough task of liquidity management while juggling FX inflows, secondary bond market purchases to keep long-term borrowing costs low and ensuring money-market rates are aligned to the policy rate,” said Kanika Pasricha, an economist at Standard Chartered Plc in Mumbai. Steps must be taken to realign money-market rates with policy rates, she said.

Reserves surge as RBI snaps up dollars

While most currencies in Asia have benefited from a weaker dollar, the rupee is down 3% this year. Traders point to how the RBI has bought $58 billion of dollars in the first nine months of the year as signs of its intervention.

Governor Shaktikanta Das has only commented very broadly on the matter, writing in the most recent policy statement that the central bank acts to damp forex volatility and keep the rupee in sync with underlying domestic fundamentals.

Inflows into India’s equity markets have grown to more than $19 billion this year, on course for the most on an annual basis since 2013. Foreign investors have also completed about $30 billion of acquisitions in cash, according to data compiled by Bloomberg.

Declines in the dollar, which is forecast to keep falling in 2021, are fueling fund flows into emerging markets globally.

In India, capital inflows may reach $82 billion by the end of the fiscal year though March, then continue at much the same pace for the following 12 months, according to estimates from Deutsche Bank AG.

“Given the multiple challenges from excess liquidity due to capital flows and inflation, the RBI may be forced to reduce the intervention and allow appreciation,” said Arvind Chari, head of fixed income and alternatives at Quantum Advisors Pvt.

The median of estimates compiled by Bloomberg is for the rupee to appreciate to 72 per dollar by the end of 2021. Analysts at Goldman Sachs Group Inc. forecast the currency as strong as 70 by March 2022. It ended trading at 73.5575 on Monday.

To be sure, some including B. Prasanna, ICICI Bank Ltd.’s head of global markets, sales, trading and research, argue that when you look at the rupee relative to a basket of its trading partners, the currency is overvalued and the RBI will have little tolerance for it to strengthen sharply.

Yields on short-dated bills have plunged due to a liquidity glut

With excess cash in the banking system estimated at 7 trillion rupees ($95 billion), key overnight rates have plunged below the reverse repurchase rate that marks the lower bound of the central bank’s policy corridor.

Lower shorter rates without a similar drop in long-term borrowing costs means a steeper yield curve, which tends to undermine efforts to stoke growth.

The pricing also points to loan rates dropping below similar tenor bond yields, which crimps profits for banks. If things stay this way long enough, it would also cause a mismatch between assets and liabilities in the financial sector, which could ripple through wider economy.

Analysts suggest the RBI will be forced address the glut early in 2021.

Among a host of options, it could allow wider access to the reverse repo window, hold variable reverse repo auctions at higher rates and set up a standing deposit facility to absorb surplus liquidity, according to economists at HSBC Holdings Plc including Pranjul Bhandari.

Other possibilities are raising the cash reserve ratio and opting not to replenish currency that leaks out of circulation, they wrote in a recent note.

But there are also fears that taking these kinds of actions could end up spooking debt markets and erode demand for government bonds.

Bulging Debt

This would be a big problem with the government selling record amounts of bonds to nurse the nation through the coronavirus pandemic.

Against this wider back drop, the central bank this month reminded markets of its capacity to deliver surprises.

While the RBI kept rates unchanged as expected at its final policy meeting of this year on Dec. 4, it dashed expectations among traders and fund managers that it was ready to start soaking up excess liquidity.

Michael Patra, the influential deputy governor in charge of monetary policy, said this month that the RBI is keeping a “very careful and close watch on the liquidity situation” and is aware that excess funds in the system can fuel inflation.

The next monetary policy decision is scheduled for Feb. 5, by which time market pressures may be even higher.

“Options for the RBI to manage and accelerate the recovery are a complex balancing of alternatives involving economic and financial trade offs,” said Saugata Bhattacharya, chief economist at Axis Bank Ltd. in Mumbai. “A range of tools will be deployed incrementally to gradually drain the system liquidity and tighten financial market conditions.”