Traders may go long on rupee

The Reserve Bank of India’s (RBI) new currency swap plan is worth comparing to the swap Raghuram Rajan set up in late 2013. The central bank will buy $5 bn from Indian banks, paying rupees and return the forex three years later, on agreed terms. The auction for this swap will be done this week.

The 2013 swap was an act of desperation. The rupee had fallen over 10 per cent, to all-time lows of Rs 67/USD in September 2013, as Rajan took charge at the RBI. The trade deficit and current account deficit were very high. Inflation was high. The gross domestic product (GDP) growth was low. Oil prices were at $100-plus/barrel. Forex reserves had fallen $16 bn (between March and September 2013) to $275 bn. Amid fears of a run on the rupee, the swap boosted RBI’s forex resources (swap proceeds were not officially accounted as reserves).

The “Das Put” as this swap is being called is harder to understand. The official narrative is that the economy is fine. Inflation is at multi-year lows. The oil basket is at $65 – $40 below the 2013 rates. GDP is said to be growing faster than in any other big economy. Reserves are just under $400 bn. And foreign portfolio investors (FPIs) are buying Indian assets in quantity.

A short explanation of how swaps work may be useful. In a swap, the RBI may for example, set a rate of, say, Rs 70/USD at the auction (the details of the last swap were confidential). The RBI pays that rate to pick up the forex. The banks will pay the same rate three years later, when the swap is closed (there may be other terms and conditions as well). Depending on the $/rupee rate three years later, either the RBI, or the banks could make a lot of money.

The banks can lend out the rupees (the RBI may hold much of the forex it receives in hard currency treasury bills). This imparts $5 bn of rupee liquidity to the bond market. One effect of the announcement has been rupee strengthening. The rupee has risen from Rs 71.75/$ in early February to Rs 68.58 this week. There has also been a drop in short-term bond yields.  

That gives us a clue as to why the RBI is looking at this instrument. Liquidity in the domestic bond market has dried up since the IL&FS crisis. That has put a squeeze on the non-banking financial companies (NBFCs) and they are the key conduit for lending out to small and medium businesses. Moreover, banks are still struggling to cope with a huge overhang of non-performing assets (NPAs). Given signs that the economy has slowed down — witness poor vehicles sales in January and February — and private investment is low, opening the credit tap may be necessary.

The injection of liquidity ahead of the Monetary Policy Review may be part of a broader plan. This action therefore, gives us a clue about the RBI’s likely stance in April. The Monetary Policy Committee may well decide to follow through with another rate cut. Inflation is genuinely low, even if it has risen slightly in February. The additional liquidity may induce banks to be less cautious about lending out.

Higher domestic liquidity is being coupled to signals that there will be higher global liquidity through 2019. The Fed may keep an accommodative stance, The European Central Bank and the Bank of Japan clearly will be accommodative, and so will the People’s Bank of China. This could mean a global “risk-on” policy with money flowing into equity and other risky assets, regardless of poor earnings growth prospects.

Lower interest rates and more liquidity could help to re-float the NBFC sector, which in turn could mean the resurgence in activity in micro small and medium scale enterprises (MSME). The banking and NBFC sector has already responded to the idea of the swap with a surge to new all-time highs for the Nifty Bank.

The long-term impact on the currency market is hard to judge. In the medium-term, the rupee may be headed for further strengthening and serious over-valuation.  A strong rupee encourages imports, and has a negative impact on exports. The trade deficit may rise. Anticipation of a stronger rupee is one reason why the information technology sector has underperformed in the last fortnight. Traders would look to be long on the rupee and to switch out of export-oriented sectors and move into financials and rate-sensitive areas.

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