The Hindu Business Line : The rupee on a roll

Against the dollar, the rupee advanced 12.5 per cent during the year. Against the euro, another currency preferred for invoicing, the rupee has remained steady from April this year. But the euro is also losing flavour among domestic exporters in view of a possible depreciation.

Capital inflows

But a large portion of the rupee’s advance stemmed from the huge capital flows during the year from foreign institutional investors, hedge funds, and non-resident investors moving out of the dollar. Besides, investments were also pouring in from countries like Japan that have traditionally stayed away from emerging markets. In fact, Japanese investors used the yen carry trade mechanism for investing in Indian markets. The yen carry trade implied borrowing in yen denominated interest rates and reinvesting the same in the high yielding emerging market securities. The obvious preference for such investors has been India, in view of the high returns and the lowest risks as against all the emerging markets in the world, including China.

Money supply, driven by foreign inflows, expanded 35 per cent on year-on-year basis, triggering inflation worries. Exporters panicked, fearing negative margins. In fact, during the year, exporters returned to hedge their exposures. Till April, exporters hedged against only dollar exposures. But mid-year onwards, most of them were hedging against the dollar, sterling pound and the euro as well.

As a result, forward for six months crashed from 5.20 per cent in April to barely 1.2 per cent currently. But during the year, six-month premia had dipped to less than one per cent.

CRR as intervention tool

Faced with this situation, the RBI moved away from the reverse repo as an intervention instrument and increasingly preferred the cash reserve ratio for mopping up liquidity generated through foreign exchange purchases.

The reason: CRR is a low-cost intervention tool. This is because there are no interest payments on the CRR. But interestingly even China has begun using the liquidity reserve ratios as a tool, after the Indian experience.

Moreover, the RBI, concerned with the fear that a liberal external commercial borrowings regime was stoking the liquidity expansion, imposed end-use restrictions. The restriction prohibited ECBs to be substituted for domestic rupee debt. Instead, ECBs were mandated to be used for only genuine capital imports.

Containing hedge funds

The capital markets regulator – the Securities Exchange Board of India (SEBI) – also stepped in to contain the hedge fund flows through an opaque instrument called participatory notes (PN). PNs were issued to hedge funds that were based in cross-border tax havens by FIIs which helped them subvert domestic registration guidelines. The new SEBI guidelines mandated that hedge funds would have to get themselves registered.

However, the impact of the measures was short-lived. The flows switched from hedge funds and ECBs to non-resident investors. Most of the funds now coming into the markets currently are from NRI investors, mostly in the form of short-term bank deposits. This is despite the low rates of interest offered. Banks’ moves to reduce rates during the last few weeks have done little to stem the flow.

The flows were to a large part on account of the interest rate differentials. After the fourth reduction in the US Federal Funds rate to 4.25 per cent, investments in India have become attractive. This was because the advancing exchange rate offset some of the losses that NRI/FCNR/NRO investors obtained from low deposit rates in India. Besides some of the investments were destined for capital markets and the slew of large public offerings that are poised to hit the stands during the next few weeks.

These flows have remained large enough to offset the impact of high global oil prices. Global oil prices are currently about $90 a barrel. Besides, attempts to make corporates prepay large foreign exchange liabilities failed to impact the exchange rates.

Sub-prime impact

But what came to the rescue of the RBI was the sub-prime crisis that has encompassed almost the entire western economy. And there are fears that even China, which has external reserves of $1 trillion, may not be free from the crisis.

In fact, due to large trade surpluses and the need to maximise returns on investments, China had diversified investments into US housing mortgages. Chinese bank’s exposure is estimated at over $14 billion, according to a US Treasury survey June 2006. The sub-prime investments has led to losses in China and likely to surface in the coming months.

The treasury survey showed that Indian holdings in US asset-backed securities are zero.

Consequently, Indian losses are negligible. The losses have mostly occurred only due to the impact of investment depreciation of investments and due to FII pull out from domestic equity markets.

No Indian bank or financial institution has directly invested in the sub- prime markets. But even for the RBI depreciation losses are minimal. Most of the external balances are held in the form of custodial balances and short term treasury balances.

Check on inflows

For the RBI, the mortgage meltdown considerably reduced the cost of intervention. The cost was in the form of a deficit between reverse repurchase rates and the returns earned from investments in dollar treasury securities.

Returns from dollar treasuries were barely 4 per cent as against the intervention costs of 6 per cent. Besides, the depreciation of the dollar has also taken away some of the gains. The CRR though helped reduce the costs even further.

However, the sub-prime meltdown and consequent Fed reaction has triggered an inflow into Indian securities, particularly from long-term pension and university funds from the US. These funds are now expected to mount in the coming months posing new challenges in exchange rate management.

Bankers are now bracing for new containment measures to check inflows and instability in the domestic markets. The CRR is one weapon.

Next year, the RBI could very well deploy a new arsenal. Perhaps sweetening ECB prepayments is just one in the pipeline.