Building buffers: Forex inflows should be used to build up reserves

Falling crude prices and US-Iran talks have eased pressure on the rupee, but RBI may continue building forex buffers amid global and domestic uncertainties

Despite uncertainty, the beginning of negotiations between the United States (US) and Iran is a big relief for the global economy. Although the fate of the Strait of Hormuz is still unclear, the progress thus far has resulted in a decline in prices of crude oil. Prices of Brent crude oil have come down by over 30 per cent from the highs of early May and are hovering around $78 per barrel. Higher prices because of the conflict had put considerable pressure on the Indian economy, and that was visible in the rupee’s value. Facing a higher balance-of-payments (BoP) deficit, the rupee declined by over 5 per cent between March and May. However, the dip in oil prices has resulted in its recovery. The rupee has gained about 1 per cent compared to the May lows. 

However, gains for the Indian currency are likely to be limited. As this newspaper reported last week, the Reserve Bank of India (RBI) seems to be intervening in the market to rebuild its foreign-exchange reserves. This is the right thing to do. India faced a BoP deficit even last financial year, and the RBI sold net $53.13 billion in the spot market. It may have continued to do so this financial year as well. Besides, it is reported to have large short positions. Both the government and the RBI have announced several steps to improve capital inflows, including incentives for external commercial borrowing (ECB) and raising deposits from non-resident Indians through Foreign Currency Non-Resident (Bank), or FCNR (B), deposits. Banks are competing aggressively for FCNR (B), and some are also offering leverage to increase returns. Some estimates suggest that FCNR (B) could attract inflows worth $100 billion. 

Some market participants expect the RBI to increase the cash reserve ratio to manage the resultant liquidity. The RBI has asked banks to submit daily reports on such deposits, and ECB mobilised through the concessional scheme. The central bank would do well to periodically make this information public. As conditions improve with a decline in crude-oil prices and the potential resumption in capital inflows, there could be calls to let the rupee appreciate. The RBI should resist such suggestions for a variety of reasons. 

First, most of the inflows under the relaxed rules are likely to be in the form of debt and will have to be repaid in foreign currency over the medium term. Thus, it will be critical to determine how the inflows are handled. Those should not be used to push up the rupee. Second, given higher inflation rates in many parts of the developed world, monetary policy could become more restrictive, resulting in tighter global financial conditions with implications for capital flows. Large central banks like the European Central Bank and the Bank of Japan raised policy interest rates in recent weeks, and markets are factoring in the possibility of a rate increase by the US Federal Reserve. Third, sustained artificial intelligence-led investment in the US may continue to attract risk capital, affecting capital flows to emerging markets like India. It is worth keeping in mind that India has witnessed substantial selling by foreign portfolio investors in the equity markets over the past 18 months. Fourth, India has witnessed a major external shock over the past few months, and a period of currency undervaluation would aid the recovery process. Finally, while the US and Iran have started negotiating, the possibility of a stalemate with unfavourable outcomes should not be ruled out. Thus, it would be prudent to build buffers over the coming weeks and months.