RBI needs to buy dollars for a stable rupee
Public memory is short. In the euphoria around a strong government taking tough/quick decisions, foreign flows are increasing, the rupee is strengthening and its near-collapse last summer—which showed just how vulnerable India was—has all but been forgotten. Between mid-May when the Fed began talking of a taper and late August, the rupee lost more than 20%, hitting 68.82 to the dollar as FIIs pulled out money from both bond and equity markets. The sharp depreciation in a matter of months didn’t just put importers in a spot, it left India Inc very vulnerable given its large foreign debt, 40-50% of which was unhedged. Interestingly, the IMF’s latest Global Financial Stability Report points out that the impact of a 30% depreciation on India Inc’s forex debt—after taking into account the natural hedges firms have—could wipe out around 22% of ebitda; BoFAML had estimated last year that, for select firms, half the EPS could be wiped out by even a 5% depreciation.
The reason why the rupee collapsed last May was that RBI simply didn’t have enough foreign exchange (FX) reserves to arrest the slide; the knowledge that the central bank couldn’t defend the rupee encouraged one-way speculation. While RBI disastrously tried to curb liquidity, the rupee didn’t start recovering till September when it announced a special dollar-window for oil marketing companies—in effect, taking away the demand from the market—and helped mop up $34 billion through FCNR(B) deposits after promising to take care of part of the hedging costs.
The lesson to be learnt—and one reiterated by Arvind Panagariya, the BJP’s reigning economic guru—is that the central bank must shore up FX reserves when it has the opportunity. In the NDA years of 1998 and 2004, Governor Bimal Jalan beefed up reserves, doubling the import cover to 15 months; overseas money was mopped up through the Resurgent India Bonds (RIB) in 1998 and India Millennium Bonds in 2001. India’s current reserves, in contrast, are around half that level—the CAD (assuming normal gold imports) and the short-term debt of residual maturity themselves add up to around $220 billion or around six months of forex cover. And just how vulnerable India still is can be seen from the fact that, as BoFAML point out, FII investment in equities currently equals 80% of FX reserves, up from around 30% in 1997—given Indian stock markets have received a third of all equity flows to EMs since 2009, this may be hard to sustain. Forget about the need to weaken the rupee to boost exports and increase import-substitution, RBI needs to buy dollars—BoFAML puts it at $80 billion over two years—to maintain even an eight-month cover, the minimum required to keep the rupee stable; 10-12 months would be preferable. Only at those levels can a strong rupee—58 or so—be sustainable.