RBI’s FX Reserves crossing the half a trillion Dollar mark created headlines recently. The RBI has been on a Reserve accumulation spree. Its FX Reserves have risen by USD 50bn since the beginning of the year, despite a net ~USD 14bn outflow from domestic equity and debt markets in the same period. FX Reserves had risen for 7 successive weeks until the week ending 12th June. We first analyze the impact that FX purchases have had on the exchange rate in REER terms, volatility in USD/INR, liquidity in the banking system and RBI’s balance sheet. We also try and analyze whether a stronger external position could structurally alter the dynamics for the USD/INR exchange rate going forward.
Impact on Relative Performance of Rupee
The Rupee has been the worst performing Asian currency year to date. Two charts below help explain the price action in Rupee, relative to other Asian currencies.
When all the Asian currencies were under the pump due to risk aversion and flight to safety, the Rupee was the worst performer. However, during the last one month, with improvement in global risk sentiment, while the other Asian currencies have been able to recoup their losses to a great extent, the Rupee has not been able to do so. The RBI has used bouts of overall global Dollar weakness to absorb inflows, thereby preventing the Rupee from appreciating. This is reflected in the real effective exchange rate (REER) of the Rupee. The overvaluation of the Rupee in relative terms has corrected by almost 3% since the beginning of the year.
(Rupee overvaluation in real terms has corrected significantly. We are below the mean REER level)
The chart on the right above shows the number of days spent in each REER handle over the last six years. The mean of the distribution is close to 114. With REER currently at 112.5 we are below the mean.
Impact on Volatility in USD/INR
Despite the Rupee being an underperformer, the RBI has managed to contain the volatility in the Rupee. Its intervention function has been asymmetric. Though the RBI has been more aggressive in preventing the Rupee from appreciating, it has intervened to prevent run away depreciation in the Rupee as well. We saw this recently when USD/INR spiked on flare up in India-China border tensions. Chart below shows the standard deviation of daily percentage changes in the currency since the beginning of the year. Volatility in the Rupee has been lower than that seen in its closest comparable peer i.e. the Indonesian Rupiah (IDR)
Impact on banking system liquidity
Persistent FX Purchases by the central bank has contributed towards keeping the liquidity in the banking system in surplus. The surplus liquidity in the banking system continues to hover around the Rs 6 lakh cr mark. Surplus liquidity has aided in monetary policy transmission. It has kept the operating Rate closer to the Reverse repo rate. Money market rates have softened by all metrics.
Impact on RBI economic capital
One of the theories behind the aggressive Reserve build up by the RBI pertains to economic capital framework. Given the government’s stressed finances, the theory postulates the idea of the central bank using the strength of its balance sheet to help the government tide over the financial stress resulting from current unprecedented times.
How a higher USD/INR helps RBI’s cause is as follows:
The approximate balance sheet size of the RBI as on 19th June 31,83,711 + 2,82,212 + 15,15,001 = Rs 49,80,924 Cr
(Rs 2,89,399 Cr is the net of what the RBI has lent to banks in the form of LTROs and what the banks have parked with the RBI has Reverse Repo. The net non-monetary liabilities of the RBI of Rs 15,15,001 Cr can be thought of as RBI’s economic capital or equity.)
The new economic capital framework requires RBI’s economic capital to be 20-24.5% of its balance sheet size.
Taking the net non-monetary liabilities of the RBI as its economic capital, the ratio of economic capital to balance sheet size works out to 30.4%. Assuming that the RBI would want to keep the ratio at 24.5%, it can theoretically transfer a surplus of around ~Rs 4,00,000 Cr to the government. (Deducting Rs 4,00,000 Cr from the numerator and denominator, the ratio would works out to ~24.5%)
However, even the economic capital is further bifurcated into Revaluation balances and Realized equity. Since revaluation gains represent unrealized valuation gains, they cannot be distributed. They can only be used as risk buffers against market risk. The provisioning for market risk is calculated as expected shortfall at 97.5-99.5% confidence level. Besides market risk, the central bank also makes provisions for monetary and financial stability risks, credit risk and operational risk to the extent of 5.5-6.5% of the balance sheet size. This is called the contingent risk buffer (CRB). Any shortfall in provision for market risk has to be met from realized equity. Only if the realized equity is more than the total provisioning requirement, the net income for the year can be transferred to the government. Consider the three scenarios below:
*Have considered CRB at 5.5% of BS in above example
If the RBI’s net income for the current year is Rs 50,000 Cr, then in the first scenario, it cannot distribute any amount at all. In the second scenario it can only distribute to the extent of Rs 25,000 Cr, i.e. after meeting the shortfall in realized equity and in the third scenario, the entire amount of Rs 50,000 Cr can be distributed as surplus. By keeping USD/INR higher, The RBI is therefore aiming for the third scenario. In this scenario it can even make a case for rolling back excess provision to give a one off bigger sum to the government. (Considering that the RBI FX Reserves are at ~USD 500bn, every Rs 1 increase in USD/INR increases its revaluation balance by Rs 50,000 Cr). This way, at a time when household, corporate, bank and government balance sheets are stressed, the strength of the RBI balance sheet can be leveraged to tide over current unprecedented times.
Finally, what does a more comfortable external position mean for the Rupee going forward?
The chart below shows that when the Reserves as a percentage of our short term external liabilities were on the decline, we were witnessing higher volatility in the Rupee. Since 2013, when the Reserves as a percentage of our short term external liabilities started increasing, we have seen a noticeable fall in implied volatility in USD/INR. Higher FX Reserves give the RBI greater influence over containing volatility in Rupee. We therefore feel, under this RBI regime, the volatility in the Rupee may continue to remain contained.
We put together our take on the major domestic and global factors driving risk sentiment over the medium term with special emphasis on political developments, monetary policy outlook and fiscal policy implications.
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