Carry positions can hurt exchange rate and cause inflation, says SBI

A huge buildup of carry positions could negatively impact the exchange rate and lead to inflation, State Bank of India’s (SBI)’s economic research arm warned on Monday.
 
“With significant open positions in USD-INR carry trade, a vibrant non-deliverable forward market with big players and a high forward premia... if due to any event, the positions are unwound, it can put significant depreciating pressure on the rupee, thus impacting inflation adversely,” wrote Soumya Kanti Ghosh, chief economic advisor of the SBI group, in a report.
 
This is particularly important for the Reserve Bank of India (RBI) as it works under an inflation-targeting regime. However, the current situation has forced it to focus more on growth, while making sure that the system is financially stable.
 
Inflation can alter by 0.1-0.13 per cent for every 1 percentage point change in exchange rate, “warranting that the exchange rate be closely monitored as a key information variable for the conduct of monetary policy”, Ghosh argued. 
 
In the RBI’s quarterly projection model, the exchange rate component does get factored in implicitly. “However, with the principle of one variable for one target, the MPC cannot explicitly target the exchange rate, while targeting the interest rate as well,” Ghosh said. 
 
Therefore, the report proposed, the RBI can adopt exchange rate-anchored inflation targeting.

 
The combination of two instruments — interest rates and sterilised intervention — to achieve price stability and exchange rate stability objectives is needed, especially for developing countries.
 
“The challenges posed by the pandemic are being exacerbated by the confounding market behaviour. However, with near-zero yields in advanced nations and a continued stance of monetary easing, the upward bias to rupee might remain through capital inflows, unless we witness a huge current account deficit owing to the rise in commodity prices,” Ghosh said.
 
After witnessing substantial capital outflows in March-May 2020, India witnessed huge inflows. Between June 2020 and January 2021, FII inflows totaled $76 billion, putting significant upward pressure on the rupee. 
 
“An appreciating currency in times when growth is a priority, is not what the central bank is looking for, as it might hamper exports growth and affect overall growth adversely. Thus, it has engaged in active forex market intervention to not let the rupee appreciate, despite the positive impact it could have on inflation,” the report said.
 
The data suggests that the RBI could be intervening heavily in the forward market.
 
From a net seller of dollar forward contracts in July 2020, the RBI turned into a net buyer and its outstanding position was $47.3 billion in January this year. The maturity breakdown shows that RBI has the highest residual maturity in the more than three months and less than one-year bracket of the amount equivalent to $44 billion, the report noted.
 
“Herein lies the future challenge. Rising forward premia makes the carry trade lucrative and inflows keep pouring which again leads to further currency appreciation and hence more liquidity overhang. In the end, there could be limits to sterilised intervention and rise in forward premia beyond a threshold. It may be noted that a high premia also deters importers from hedging their dollar positions,” Ghosh said.