A delicate balancing act awaits India’s central bank as it tries to build foreign-exchange reserves and support the bond market.
The Reserve Bank of India’s aggressive purchases of dollars has seen excess banking liquidity top levels seen after the government’s currency ban in late 2016.
That’s raised questions over its capacity to buy large chunks of bonds without adding to the cash deluge just when the nation is issuing record debt.
“RBI should be able to do open-market operations or direct monetisation” of debt despite the abundant liquidity, said Suyash Choudhary, head of fixed income at IDFC Asset Management Ltd. “In the current context, bond purchases aren’t related to the objective of liquidity creation – they are means of financing support for the government.”
The crux of the issue for investors is how much of the excess cash should the RBI allow to slosh around.
Some say the surplus liquidity won’t stoke consumer prices because of weak demand, while others point to the years after the 2008 global financial crisis when India’s inflation hit double digits due to stimulus.
The forex mop-up has pushed up India’s reserves past the $500bn mark to a record and boosted banking liquidity to Rs6.1tn ($81bn). In the absence of demand for loans, banks are funneling a bulk of this cash into short-term sovereign debt.
That’s causing the yield curve to steepen.
Citigroup Inc expects the central bank to resume open-market measures by end of July and scale it around the fiscal second-half of the borrowing plan which begins October 1. The RBI has so far been restrained in its debt intervention, having bought Rs1.2tn of notes and done two rounds of Federal Reserve-like Operation Twists since April 1.
“The dilemma for RBI will be sharper going into the second-half borrowing” plan, said Prasanna A, chief economist at ICICI Securities Primary Dealership Ltd. “For now, the RBI has some breathing space as yields have been relatively well behaved.”
The benchmark 10-year yield dropped 16 basis points in the last two weeks after a round of Operation Twist, leaving traders expecting more support.
It was trading at 5.83% yesterday, up seven basis points for the week in the absence of further purchases.
How the RBI views its forex hoard – the fifth-largest in the world – will also decide the size of its intervention in the currency and bond markets, analysts say.
While $500bn make for good optics, some forecasters including Standard Chartered Plc say there’s a need to boost reserve adequacy to protect the economy.
The RBI likely sold Rs1tn in spot forex intervention in the April-June period, an amount ICICI Securities had factored in for the entire year, said Prasanna.
That means open-market debt purchases may come in at the lower end of the Rs3tn-Rs6tn estimates, he said.
Moves in the rupee are also being parsed for clues.
A recent bout of appreciation sparked speculation the central bank slowing down its dollar purchases, though traders say the RBI has returned to buying forex.
One view is that the authority may lean on forwards market, which could help push back liquidity injection to a future date.
“Will the RBI continue to buy FX as lower trade deficit pushes up the balance of payments surplus? We think it will broadly continue to buy FX when the USD weakens and let INR depreciate when USD appreciates,” Bank of America economists Aastha Gudwani and Indranil Sen Gupta wrote in a note.
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