RBI hopes to shore up weakening rupee by using Chinese playbook

Why in the News

For the first time, Indian banks must park cash with the Reserve Bank of India (RBI) against large forex derivative contracts involving the rupee, which makes hedging against a falling rupee costlier. The RBI announced this Foreign Exchange Risk Reserve (FERR), borrowed from China, in a set of measures to defend a rupee trading close to its all-time low.

What is the FERR, and why make hedging costlier?

1. What it is: A bank must set aside 20% of any forex derivative contract above $2 million involving the rupee, as cash with the RBI. The RBI can change the percentage.
2. Hedging: Hedging means locking in today’s exchange rate for a future payment, like buying insurance against the rupee falling before an importer’s dollar bill is due.
3. Hedging as dollar demand: Authorities usually encourage importers to hedge. When the rupee is under strain, every hedge against its fall is a purchase of dollars, so hedging itself pushes the rupee down.
4. Target: The measures aim at local banks and traders, not foreign ones.
5. The takeaway: The RBI has chosen to raise the cost of protection against a weak rupee, so that fewer dollars are bought at home when the currency is under strain.

Why is the rupee under pressure?

1. Record low: The rupee is down almost 7% against the dollar this year and hit a record low of 96.96 per dollar in May.
2. Failed rate hike: The RBI raised the repo rate, its lending rate to banks, by 25 basis points to 5.5%. Costlier money should cut the supply of rupees and lift its value, yet the rupee fell.
3. Trade deficit pressure: India buys more from abroad than it sells, so more foreign currency leaves than enters. Scarce dollars cost more rupees, and the rupee weakens.
4. Own currency trade: India and others are settling more trade in their own currencies, which cuts the need to hold dollars and the exposure to sharp swings.

What is China’s playbook, and why is India’s problem the opposite?

1. China’s reverse move: In March, China cut its own FX risk reserve ratio from 20% to zero, because the yuan was strengthening. India, with a weakening rupee, is adding the cost that China removed.
2. Undervaluation charge: The People’s Bank of China (PBoC) has rejected accusations that it keeps the yuan cheap to boost exports. It credits its trade surplus to four decades of reform and innovation.
3. Effective exchange rates: The nominal effective exchange rate (NEER) measures a currency against a basket of partner currencies. The real effective exchange rate (REER) adjusts it for relative inflation.
4. Yuan’s price edge: Nomura finds the yuan’s NEER and REER have diverged since early 2022, because Chinese prices barely rose. This has kept Chinese exports price competitive.

Challenges

1. Short term relief only: Bank economists call the measures breathing room, reminiscent of the 2013 taper tantrum. The rupee’s medium term path depends on global factors and the Balance of Payments.
2. Costlier protection for importers: Firms with genuine dollar bills now pay more to hedge, so they carry more exchange rate risk.
3. Regulatory unpredictability: The RBI is sometimes accused of changing market rules through regulation, which makes participants wary of its next move.
4. Deficit untouched: A reserve on derivatives does not change the trade gap that keeps foreign currency scarce.

Way Forward

1. Calibrated ratio: Use the RBI’s power to vary the reserve, and lower it as pressure eases, as China did when its currency strengthened.
2. Genuine hedgers spared: Exempt documented import and export hedges, so the reserve falls on speculative bets.
3. Rupee settlement: Widen trade invoicing in rupees and partner currencies to cut everyday demand for dollars.

Conclusion

The RBI is now defending the rupee by taxing protection against its fall, reversing the usual advice that firms should hedge. How soon it lowers the reserve, and whether the rupee holds once global pressures reassert themselves, is what to watch.

Back2Basics: Taper tantrum (2013)

1. What happened: The United States Federal Reserve signalled in 2013 that it would slow, or taper, the bond purchases it used to pump money into markets.
2. Effect on emerging markets: Foreign investors pulled money out of emerging markets, and the rupee fell past 68 to the dollar within months.
3. India’s response: The RBI opened a concessional swap window for Foreign Currency Non-Resident (Bank) (FCNR(B)) deposits, which raised about $34 billion, including banks’ overseas borrowing.

Matching Previous Year Question

“[2022] With reference to the Indian economy, consider the following statements : 1. An increase in Nominal Effective Exchange Rate (NEER) indicates the appreciation of rupee. 2. An increase in the Real Effective Exchange Rate (REER) indicates an improvement in trade competitiveness. 3. An increasing trend in domestic inflation relative to inflation in other countries is likely to cause an increasing divergence between NEER and REER. Which of the above statements are correct ? (a) 1 and 2 only (b) 2 and 3 only (c) 1 and 3 only (d) 1, 2 and 3 ANSWER: (c)”