How much more can the RBI intervene?

The fact that we are much better protected today might just explain the RBI's reluctance to bring in a biggish chunk of dollars from NRIs either through bonds or dollar deposits as it did in 2013

The recent debate on the costs and benefits of a falling rupee must have done its bit to reinforce the stereotype of economists as a bunch of people who are pathologically averse to agreeing with each other. That said, the majority of our ilk perhaps concede that another round of rapid depreciation might be detrimental to both the economy and the financial markets and some form of intervention is desirable.

Let’s address the issue of how much more the Reserve Bank of India (RBI) can do to prevent a full-blown run on the currency. In doing this, it might be sensible to ask the following questions: How much more or less vulnerable are we compared to another period of external stress? What is that other period? Should we look at the 2008 global financial crisis or the sell-off in Asian markets 1997? Or is there a more recent benchmark? 

We think that the May 2013 “taper tantrum” — the panic selling of emerging market currencies when the then US Federal Reserve Chairman Ben Bernanke hinted at a reduction in monetary stimulus (quantitative easing) that took the rupee down by 28 per cent over a span of four months — might be the relevant benchmark. For one, it is recent enough to obviate the need to make adjustments for “structural” changes in the international financial environment that a comparison with an earlier episode would entail. Second, like the current “crisis”, the taper tantrum was principally an emerging markets problem that hit economies with current account deficits the hardest.

This leaves us to grapple with the meaning of vulnerability itself. Four hundred billion dollars of reserves might seem like a lot of money but are we really more protected than we were during the 2013 tantrum? One way to figure this out is to net out the amount of dollars that is sure to leave our shores over the rest of the year. Short-term debt is perhaps the best proxy for this. Thus the difference between reserves and short-term debt tells us the following thing: If none of this debt was rolled over (like all good stress measures, it builds an extreme scenario) and all the outflows were to be met from reserves, this would be the amount of dollars left with the central bank that it could use to fill other gaps in dollar demand and supply.

This estimate should bring the few remaining rupee bulls some comfort. The ‘spare reserves’ that we have left after servicing short-term debt is $287 billion compared to $120 billion at the time of the 2013 crisis. (Data for short-term debt is available only for the full year and we assume half of this debt would have already matured in the April-September period). If we take this as a percentage of GDP to compute the so-called vulnerability ratio we are at 10.9 per cent today compared to 6.4 per cent during the tantrum. A higher ratio means lower vulnerability.

The fact that we are indeed much better protected today might just explain the RBI’s reluctance to bring in a biggish chunk of dollars from NRIs either through bonds or dollar deposits as it did in 2013. However, it might also leave us wondering why the RBI did not intervene more to halt the rupee as it moved sharply from a level of 69 to now around 73 over just about a month and a half. Did it have an exchange rate target mind? The range of 72 to 73 is incidentally the range where all the overvaluation in the conventional six-country REER with a 2004-05 base is erased? Or was it just keeping its powder dry for yet another bout of depreciation pressure on the rupee that it anticipates?  

There is a lesson in it for policymaking as well. Encouraging short-term inflows might appear to be just the ticket in the near term but what they end up doing is to increase vulnerability (reduce the vulnerability ratio) beyond that. This might make the currency even more susceptible to a fall going forward. From that perspective, governments’ recent measure to allow companies to borrow externally up to $50 million with a minimum one-year tenure compared to three years earlier might just have sent mixed signals.

However, this simple gauge of vulnerability does not mean that all the $287 billion of spare reserves can be deployed in the market to defend the rupee. There is a threshold below which reserves might cease to be “adequate”. The IMF’s (“Guidance note on the assessment of reserve adequacy and related considerations”, 2016) reserve adequacy framework is a good measure of the capacity of a central bank to use its forex reserves to intervene in the markets. 

This builds in different sources of stress on the external accounts such as loss in export income, outward remittances by residents in a flight to safety, portfolio outflows as well as the need to service short-term debt in the absence of rollovers. These are combined in a model to yield the “adequate” level of reserves to meet these contingencies. A possible interpretation is that if actual reserves are equal to this “adequate” level, then the central bank has just enough insurance for a really rainy day. If it wishes to intervene much more, it has to consider replenishing its reserves.

We adjust this model a little to calculate how much the RBI can draw from its reserves pool. Our conclusion: India’s current reserves are close to 120 per cent of this adequate level. This works out to be close to $65 billion of additional intervention capacity without the RBI having to fret about “buying” more protection.
 

In brief, the RBI still has the upper hand. Its intervention is likely to be far more effective in stabilising the rupee than other policy measures taken by the government or itself. If 72-73 is indeed the ‘fair value’ of the rupee or there is the prospect of a runaway inflation or there is a risk of accelerated capital flight, it can hold this level. Thus the current level of the rupee could well be the one at which it consolidates.

Barua is chief economist and Arora, senior economist at HDFC Bank