The redemption of the FCNR (B) deposits in September is the next big thing to watch out for. Around $25 billion will have to be paid back by banks as it is assumed now that there will not be a rollover to this extent.The balance $8-10 billion that came in would remain with the system. Repaying a sum of $25 billion is a task given the quantum involved. The RBI has assured the market that two things have been done. The first is that they have already gone in for forward transactions gradually which means that the central bank will be getting in dollars to repay these deposit holders. And second, if need be, the central bank will access our forex reserves kittyof around $365 billion to ensure a smooth transaction. There are two areas which will require close scrutiny.
The first pertains to the exchange rate, while the second is in the area of liquidity. Our forex reserves have been increasing continuously over the last couple of years. From September 2013 onwards, there has generally been only an increase in forex reserves which was due to these deposits to begin with. Subsequently, the reserves have been increasing aided by a combination of a favourable current account deficit and strong capital inflows, especially from FDI en while FPIs have been rather dormant.
How will the currency be affected? In recent forex history, the rupee took a major hit from May 2013 onwards when the Fed had spoken of the tapering of the Quantitative Easing (QE) programme. This was the time when crude oil prices were rising and our gold imports expanded unhindered.
Between April 2013 and September 2013, the rupee was hit hard and declined from Rs 54.38 to Rs 63.75/$, a drop of a little above Rs 9. Forex reserves had declined sharply by almost $20 billion due to a combination of these reasons. The rupee got hit even more severely by the speculative elements and the NDF market which exaggerated the fundamentals. How will the rupee be impacted now?
Based on fundamentals, the exchange rate is determined by the demand and supply for forex which gets reflected ex-post in the balance of payments statement through change in reserves. Intuitively, a positive accretion to reserves indicates a stronger rupee. Some degree of volatility comes in when sentiment accelerates beyond the fundamentals. The balance of payments situation appears fairly positive with net inflows expected after adjusting the current account deficit with capital inflows. A regression analysis, which links change in exchange rate with the change in forex reserves, shows a strong and significant relationship between the two variables.
The relation indicates that for every $1 billion fall in forex reserves, the currency could be impacted by between 50-60 paise (depending on various models being used including lags). With the assurance of the RBI being there, the speculative attack will be minimised. The forward purchases from earners like exporters will address this issue on an incremental basis but then will not get added to the reserves in future which would have happened in the normal course.
Hence, the decline in the rupee cannot be eschewed, and while the decline in rupee will not be of a proportionate order of Rs 5.5-6, a movement towards Rs 68-69 would be expected, especially when the outflow takes place. The second issue which has been addressed by the RBI already is the impact on liquidity. As the RBI keeps buying dollars in the market, two things happen. First, liquidity is provided to the system and second, the rupee is held stronger and appreciation is prevented.
Now with banks buying dollars back from RBI, liquidity would be taken out and, hence, the RBI may be expected to become more aggressive with open market operations to ensure that the money market remains stable. Fortunately, this situation can be addressed with some convenience as the demand for credit has not yet picked up and when it will, this issue would have been tided over. But the timing will be important and the two have to be synchronised as this will affect interest rates on a real time basis. This will also be one of the other reasons for one to expect the RBI not to consider a rate cut at this juncture even if inflation starts moving downwards.
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