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The dollar dilemma

Tamal Bandyopadhyay | April 17, 2003

It hasn't been raining; it's been pouring. But the inter-bank foreign exchange market, the catchment area of the dollar rain, is running dry because the flow has been steadily drained out of the market into the Reserve Bank of India's reservoir of foreign currency assets.

The net result? A bundle of contradictions: ballooning foreign exchange reserves; a hardening rupee, crashing forward premiums, a low interest rate outlook, excessive rupees in the system but a dry, liquidity-starved inter-bank forex market.

Last week, the six-month annualised forward premiums on the dollar dipped below two per cent for some time before bouncing back. The one-year forward also crashed to a new low. What's more, the cash-tom (the one-day rupee-dollar swap) premium also ruled at a discount for a few days.

Forward premiums (or forwards) reflect the rupee's outlook and factor in domestic money market conditions and interest rate differentials between the US and India. Why are they crashing? Because of the all-round bullishness on the Indian rupee.

Exporters are selling forwards because they feel that the rupee will strengthen and importers are not booking forwards to hedge their positions because they feel the same way.

Let's look at the movement of the rupee and the country's forex reserves. The rupee hit its historic intra-day low against the dollar on May 16 last year when it touched 49.08. Its closing low against the greenback was 49.0450/ 0550, recorded on June 3. Since then, it has been a one way street for the Indian currency.

Last week, the rupee closed at 47.35 registering a gain of Rs 1.70 or 3.59 per cent over the last ten months, since June last year when it hit its lowest against the dollar. During this period, $19 billion has been added to the forex reserves.

Since liberalisation, the rupee has been losing four or five per cent against the dollar every calendar year. For the first time last year, it gained 1.08 per cent. In the first three and half months of calendar 2003, it has already gained 1.35 per cent.

The latest Reserve Bank of India report on currency and finance has outlined four policy options to deal with the excess dollar supply:

  • The first is to allow the rupee to appreciate. This may weaken the country's export performance and the balance of payment situation could turn unsustainable. In such a situation, any change in market expectations could induce a reversal of capital flows and trigger a crisis.
  • The second is tightening regulations for capital inflows, which the RBI wants to avoid given the larger financing requirements for economic growth.
  • The third is to speed up the process of capital account convertibility and put the rupee on a full float. But the RBI is not comfortable with the idea yet since some pre-requisites for a full float -- a lower fiscal deficit, for one -- have not yet been fulfilled.
  • The last and acceptable option is to absorb capital inflows in the form of higher foreign exchange reserves.

The RBI's dollar kitty is swelling because it has continuously been mopping up greenbacks from the market. For every dollar the RBI buys from the market, an equivalent amount of rupees gets injected into the system, adding to excess money in the system or the liquidity overhang.

In the second stage, the liquidity gets sucked out by the RBI through the repurchase (repo) route. Although the central banks pays 5 per cent for the overnight money parked in its repo window, the excess liquidity in the system has driven down the one-year implied rupee curve to around 4.15 per cent.

This is a derivative product on the rupee-dollar forward premium curve used by treasury-savvy Indian corporations to hedge their dollar exposures. The implication of this trend is that the central bank is offering a higher rate for one-day rupee funds than the price at which companies are raising dollar funds for one year.

If this is one anomaly in the interest rate structure, a greater anomaly is the drying up of inter-bank dollar liquidity just as the country's forex reserves are burgeoning. This is because every dollar is sucked out by the central bank.

Banks' access to dollar funds could be widened by giving them the freedom to fix the deposit rates on foreign currency non-resident resident (B) -- FCNR(B) -- loans. But the banks have exhausted their FCNR(B) (Foreign Currency Non-Resident (Banks)) deposit kitty because corporations have lapped up the cheap money. Fresh accretions to FCNR(B) deposits has been low because non-resident Indians find the rupee NRE (Non Resident (External)) deposits more lucrative.

The FCNR(B) deposits rates are capped at 25 basis points below Libor. Since one-year Libor is at around 1.37 per cent now, banks cannot pay more than 1.12 per cent on these deposits. NRE deposits, on the other hand, offer around 6 per cent on rupee deposits. NRE deposits are accepted in dollars which are converted into rupees and reconverted to dollars when the deposits are redeemed.

Even if a depositor want to hedge his position by taking forward cover, he still makes money because the interest rate works out over 3 per cent (6 per cent minus the cost of a one-year forward cover of 2.63 per cent).

It's a classic Catch-22 situation for the RBI. What can it do to bring sanity back to the market? It can buy forwards to iron out temporary glitches, as it did last week. But this is not a permanent solution. The RBI's intervention may prop up the forward premium rate for a time but as the forward rates rise, it will trigger fresh sales by exporters and bring the rates down again to unsustainably low levels.

A feasible solution could be to get importers to cover their positions. But importers will start booking forwards only when they feel that the euphoria over the rupee's strength will not last. The end of the Iraq war may signal the end of the dollar's weakness.

Last Friday, the dollar rose as much as 1 per cent against the yen and 0.8 per cent against the euro last Friday following the widespread sentiment that the US economy will do well in the aftermath of the war.

Traditionally, the rupee has always suffered a rude shock whenever it has been held at one level for long or appreciated.

In the past, the south-east Asian crisis, US sanctions following the Pokhran tests and even former RBI deputy governor Y V Reddy's apparently innocent observation at a forex dealers' conference in Goa that the rupee was over-valued on a real effective exchange rate (REER) basis, all caused the rupee to weaken.

In 1995, in five months between August and December the rupee lost nearly 10 per cent -- from Rs 31.60 on August 16 to Rs 35.15 on December 31. Similarly, after holding rock steady in 1996 and a large part of 1997, the rupee tumbled from 36.85 to 39.45 in a fortnight between mid-November and early December 1997.

In 1998, too, the rupee lost nine per cent in sudden jerks to end the year at 42.50. For all one knows, the next trigger could come from a possible Indo-Pak conflict, which may take the bottom out of the Indian currency, catching importers off guard.

The RBI may have perfected the balancing act of dollar buying and draining rupee liquidity to an art but there is a limit to how far the central bank can manage the three horses: interest rates, exchange rates and the inflation rate.

Sooner or later, it may have to let one loose and focus on the others. It is up to the regulator to decide which one should be market-driven: the interest rate or the exchange rate.

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