The large supply of dollars will ensure that rupee will appreciate from the current levels, and this could potentially play to the advantage of the Reserve Bank of India (RBI) in inflation management, according to State Bank of India’s economic research report Ecowrap.
“The good thing is that given the prospects of higher domestic inflation, as supply disruptions mount, it is not doing any harm for the RBI to lean with the wind and let rupee appreciate as it is reducing imported inflation when metal prices are rising, and clearing the liquidity overhang to some extent,” said Soumya Kanti Ghosh, Group Chief Economic Adviser, SBI.
Referring to the rupee gaining 154 paise between April 12 (75.0550 to the dollar) to May 7(73.5175 to the dollar), SBI’s economic research department believes that this is perhaps the result of exchange rate anchored inflation targeting that the RBI has assiduously shifted to recently.
Changes in QPM
This is also evident from the recent changes in the RBI Quarterly Projection Model (QPM) model that has been calibrated to include balance of payments and exchange rate interactions as well, it added.
“So, what has changed? In the merchant market (in both spot and forward segment) there was an excess supply of $86 billion during April 2020 to February 2021.
“However, in the interbank market there has been excess demand of $72 billion. Overall, merchant dollar supply is far higher than demand as they anticipate a stronger rupee and hence may be holding to short position in dollars, without even adequate hedging,” said Ghosh.
This is being balanced by excess dollar demand in interbank market, but the net effect is a large supply of dollars at $14.4 billion, that has however reduced to $348 million in the last five months ended February 2021, he added.
Ghosh assessed that the supply of dollars in the spot market during April 2020 to February 2021 by the merchant segment was as much $101 billion, while in the forward merchant segment, there is an excess demand of $14.7 billion.
The interbank market, however, shows an excess demand in both the segments at $14.7 billion.
To neutralise any additional liquidity, the RBI is also intervening in the forward markets through swaps. The RBI is doing what is called a sell/buy swap, where it is selling the dollars now to buy it back at a future date and paying a premium.
“Intervention in forward market is an important aspect of maintaining financial stability, although the move has been gradual.
“Going by John Sparos (Economic Journal, 1959), the best way to fight currency speculation is to deliberately let the forward premia rise to unreasonable levels and thereby penalise the currency speculators as their exchange rate expectations about a depreciating domestic currency are belied,” said Ghosh.
The report underscored that 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 level. It may be noted that a high premia also deters importers from hedging their dollar positions,” opined Ghosh.