You can run, but you can't hide

Foreign exchange reserves have shot higher by a record $5 billion in the two weeks ending August 5. While global investment interest in India is high, FII inflows are seldom more than $1 billion a month; so it is clear that the huge surge in reserves is a direct reflection of the RBI's continuing obsession with preventing the market from asserting itself.

Unsurprisingly, this obsession is causing considerable instability in the forex market with near-term forwards in a discount for the first time since June 2004. Short-term liquidity has surged and MIBOR has fallen below 5 per cent for the first time in several months.

So, what's going on?

Well, it all started on July 22, right after the revaluation of the Chinese yuan. Before that, the market was quiescent, with spot at 43.50 and the forwards in a steady state around 2 per cent per year, which kept the global arbitrage window effectively closed. Come the Chinese revaluation and the rupee knee-jerked higher, breaking through the six-year-old resistance of 43.25, awakening the snorting nostrils of the RBI.

From the next morning, they came in guns ablaze, buying dollars like there was no tomorrow. They succeeded in stemming the rot, and the rupee steadied back to around 43.50. By the end of the following week, they had bought a record $3 billion. Normally, the RBI would balance its dollar buying with active sterilisation, selling government securities to suck out the rupees released.

This would prevent money supply from shooting higher and keep the money market calm. However, the intensity of buying was so great that they must have run out of securities to sell -- the market stabilisation bonds they had issued were reportedly down to about Rs 10,000 crore (a bit over $2 bn) a month or so ago. As a result, liquidity started to increase and short-term interest rates fell.

In its continuing attempt to dictate to the market, the RBI kept up its dollar buying the following week, sucking up a further $2 billion. The rupee remained around 43.50, but by this time, the RBI's grotesque demand started squeezing the supply of dollars in the market.

Banks, from whom the RBI was buying dollars, had to find dollars somewhere, so they started entering into buy (spot) sell (forward) swaps, putting pressure on the forward premiums, which, finally, collapsed under the pressure and moved into a discount last week.

Now, even though the Indian market is not fully convertible, the forwards are generally in a premium, reflecting the fact that Indian interest rates are higher than US interest rates. Thus, forwards being in a discount is an aberration.

The first time (in recent years) that we encountered this was in September 2003. With exporters selling -- since the view was for a stronger rupee -- this was, at first, not surprising.

However, as the premiums pushed further and further into a deep discount, it became apparent that this was because of a huge shortage of cash dollars, which was a result of large forward contracts (maturing in September/October 2003) undertaken by the RBI to ensure that there would be no pressure on the spot market when the Resurgent India Bonds were redeemed.

Banks, who had sold forward to the RBI, needed dollars to fulfil these contracts and the only way they could get them was by selling forward at steeper and steeper discounts.

This cash shortage lasted over three months, with the spot USD appreciating as much as 50 paise, while the forwards remained in a discount. Significantly, this forward discount triggered huge arbitrage inflows, which kept pushing the reserves higher, even as the rupee appeared weak.

The premiums went into a discount again in April 2004, although this was probably directly related to huge exporter selling when the RBI stopped buying dollars (because it had run out of assets with which to sterilise their dollar purchases) and the rupee strengthened off the charts in end March. These discounts also stayed in the market for nearly two months.

The common thread in all of these instabilities -- including the current one -- is the RBI's belief that its policy of buying dollars to "prevent excessive rupee volatility" is engendering stability.

Sure, the spot is stable -- volatility is just peering above 3 per cent -- but the forward market is in a shambles, the arbitrage window is gaping wide, threatening to destabilise the RBI's dollar buying, and any semblance of sound risk management has been thrown to the winds.

Fortunately, inflation remains contained, but with oil prices completely out of control, it is probably only a matter of time -- perhaps a matter of days -- before domestic petroleum product prices are hiked. At this time, the RBI's ill-advised forex policy will be shown up in rising inflation, possibly higher interest rates (the next monetary policy announcement is in October) and, ultimately, a stronger rupee.

As far as the market goes, you can run, but you can't hide. Even if you are the Reserve Bank.