A relentless stream of money pouring into Indian markets could affect the central bank’s delicate balancing act in 2021.
For most of this year, the Reserve Bank of India has capped currency gains as global investors poured around $ 50 billion in stocks and holdings in companies. This has increased the liquidity of the rupee in a banking system that has already been flushed with cash from the RBI’s stimulus measures.
Traders and fund managers increasingly agree that mounting pressures – particularly the glut of liquidity that is distorting money markets – could lead the central bank to consider a range of changes, from easing its grip on Asia’s worst performing currency to towards the restriction of bond purchases.
A modest rise in the rupee over the past month could mean that policymakers are already getting to the heart of the intervention or that inflows are starting to overcome it.
“We believe that RBI faces a difficult liquidity management task as it balances foreign exchange inflows, purchases from secondary bond markets to keep long-term borrowing costs down and ensure money market rates are aligned with policy rates,” said Kanika Pasricha , an economist at Standard Chartered Plc in Mumbai. Steps need to be taken to align money market rates with policy rates, she said.
While most currencies in Asia have benefited from a weaker dollar, the rupee has fallen 3% this year. Traders point out that RBI bought $ 58 billion in the first nine months of the year as a token of its intervention.
Governor Shaktikanta Das commented on the matter at great length and wrote in the latest policy statement that the central bank will curb currency volatility and keep the rupee in sync with underlying domestic fundamentals.
Inflows into Indian stock markets have soared to more than $ 20 billion this year, on an annual basis since 2012. Foreign investors have also made cash acquisitions valued at around $ 30 billion, according to Bloomberg.
The decline in the dollar, which is expected to continue to decline in 2021, is fueling fund flows to emerging markets worldwide.
In India, capital inflows could reach $ 82 billion by the end of the fiscal year through March and, according to Deutsche Bank AG estimates, continue at about the same pace for the next 12 months.
“Given the multiple challenges of excess liquidity from capital flows and inflation, RBI may be forced to reduce intervention and allow appreciation,” said Arvind Chari, head of fixed income and alternatives at Quantum Advisors Pvt. Ltd.
The median of Bloomberg’s estimates is that the rupee will rise to $ 72 per dollar by the end of 2021. Analysts at Goldman Sachs Group Inc. forecast the currency will be as high as $ 70 by March 2022 on Tuesday.
While some, including B. Prasanna, head of global markets, sales, trade and research at ICICI Bank Ltd., argue that when the currency is overvalued when you look at the rupee in relation to a basket of its trading partners, the RBI will have little tolerance for it have to strengthen themselves greatly.
With an estimated surplus of cash in the banking system of nearly 7 trillion rupees ($ 95 billion), the base rate for overnight stays has fallen below the reverse buyback rate, which marks the lower bound of the central bank’s policy corridor.
Lower shorter interest rates without a similar decline in long-term borrowing costs mean a steeper yield curve, which tends to undermine efforts to stimulate growth.
Pricing also suggests that lending rates may fall below similar tenor bond yields, detracting from banks’ profits. If it stays that way long enough, it would also create an asset-to-liability mismatch in the financial sector, which could affect the economy as a whole.
Analysts assume that the RBI will be forced to fight the tide in early 2021.
According to a variety of options, it could allow wider access to the reverse repo window, run variable reverse repo auctions at higher interest rates, and set up a permanent deposit facility to absorb excess liquidity, according to economists at HSBC Holdings Plc, including Pranjul Bhandari .
Other options include increasing the liquidity reserve ratio and opting to replenish non-exiting currencies, according to a recently released statement.
But there are also fears that such measures could scare debt markets and undermine demand for government bonds.
This would be a big problem as the government is selling record amounts of bonds to care for the nation through the coronavirus pandemic.
With that in mind, this month the central bank reminded markets of their ability to surprise.
While the RBI left interest rates unchanged as expected at its last meeting on December 4 this year, it disappointed traders and fund managers’ expectations that it was ready to take on excess liquidity.
Michael Patra, the influential deputy governor for monetary policy, said this month that the RBI is “very carefully and closely watching” the liquidity situation and is aware that excess funds in the system can boost inflation.
The next monetary policy decision is planned for February 5th. Until then, the market pressure could be even higher.
“The options for the RBI to manage and accelerate the recovery are a complex balance between alternatives that involve economic and financial tradeoffs,” said Saugata Bhattacharya, chief economist at Axis Bank Ltd. in Mumbai. “A number of tools are being deployed gradually to gradually reduce system liquidity and tighten financial market conditions.”