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5 reasons behind RBI's sudden 'hands-off' policy in forex market

The RBI's earning from Rs 35.40 lakh crore of forex reserves is just 2.65 per cent as revealed in the annual report 2019-20

twitter-logoAnand Adhikari | September 3, 2020 | Updated 12:21 IST
5 reasons behind RBI's sudden 'hands-off' policy in forex market
The two big revenue generating assets in the RBI's balance sheet are domestic assets and foreign exchange assets

The Reserve Bank of India's (RBI) policy of not intervening in the foreign exchange market to buy dollars in the last two months has resulted in rupee appreciating from Rs 75 plus in May to Rs 72 against the US dollar. The rupee was trading weaker today, but it has witnessed sharp appreciation in a very short period of time. What could be the reasons for RBI pulling out from the foreign exchange market?

More than sufficient foreign exchanges reserves

The country's foreign exchange reserves at $538 billion are enough to cover a year's imports. In fact, the subdued activity on the trade front post COVID-19 pandemic shows that the reserves are more than enough to take care of any eventuality. There was a danger of foreign portfolio investors or the hot inflows bidding goodbye to India after the pandemic, but exactly the reverse has happened with foreign investors pouring record money into Indian financial markets. The success of QIPs or equity offering by the private sector banks also shows the interest of global institutions in the banking system.

Foreign exchange reserves offer low yield or interest, and increases balance sheet risk from  weakening dollar

The RBI's earning from Rs 35.40 lakh crore of forex reserves is just 2.65 per cent as revealed in the annual report 2019-20. The two big revenue generating assets in the RBI's balance sheet are domestic assets and foreign exchange assets. The domestic assets or investment in government securities yields almost the double of foreign currency assets. Currently, more than two third of the assets of the RBI are locked in foreign currency assets. Any further growth in foreign assets or rise in their share in the balance sheet will have implications on the revenues and surpluses of the central bank. The dollar has already depreciated 10 per against the Euro in the last three months. A sharp depreciation in dollar means lower revaluation gains for the RBI.

High cost of sterilisation and liquidity mop up

The RBI's intervention in the forex market to buy dollars increases rupee liquidity in the banking system as dollars are exchanged for rupee. This intervention exercise actually increases liquidity in the system. The RBI mops up surplus liquidity from reverse repo window at 3.35  per cent currently. This means RBI is paying the banks from its pocket rather than lending to them under repo window. In the last one year, the RBI's reverse repo operations have resulted in an net interest outgo of Rs 12,904 crore. The system is currently in surplus model with repo rate almost ineffective as banks are depositing excess liquidity back under the reverse repo window.

RBI comfortable with appreciating rupee

The RBI has always resisted appreciation of rupee against the dollar as it leads to uncompetitiveness of exporters in international market. While India has other issues like quality, high cost of production, interest etc , the currency does play a role in lowering the cost in international market. The RBI's current hands-off policy also shows that the central bank is comfortable with an appreciating rupee at this juncture. This will help the importers. More than the RBI, the government also seems to be in sync with the policy of rupee appreciation at this juncture when things are difficult and the RBI is doing all the firefighting, and also managing the government's huge borrowing programme.

Appreciating rupee as an inflation tool

The RBI for the first time has gone on record to say that the recent appreciation of rupee is working towards containing imported inflationary pressure. This is a very big indicator that the RBI will let the rupee float based on demand and supply. At a time when the RBI has almost exhausted the interest rate tool to support the economy, the threat of high inflation and also to manage the yield for the government borrowing programme can only be handled at best through the currency route in the short term. An appreciating rupee will lower the cost of oil imports and also imports of essential raw materials from the world, and more particularly from China, due to disruptions in supply chains.

Also read: 'Public going through hell' due to interest on interest: Borrower tells SC on loan moratorium issue

Also read: Risk-averse banks still wary of NBFCs, MSMEs, shows RBI data

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