The Reserve Bank of India (RBI) has a time-tested response every time rupee liquidity swells to an unmanageable surplus or is too deep in deficit and undermines the central bank’s ability to intervene in the foreign exchange market: it intervenes in the forward market.
The central bank is back to doing this now, to not just stem the rupee’s rise but also prevent the undesired outcome of adding to an already colossal level of liquidity. For every dollar it buys, RBI releases rupees into the banking system, which is already awash with surplus cash after demonetisation. By buying forward contracts instead, the central bank can postpone such an infusion.
RBI’s net outstanding position in the forward market in February trebled to $2.84 billion, according to data from the central bank. Movements in the forward rates ultimately influence the day’s spot market as well. The objective of stemming the rupee’s rise is met while deferring the consequence on liquidity.
Of course, RBI turned a net buyer of dollars in February by buying $1.19 billion in the spot market. But this is not a large mop-up in the wake of an inflow of $2.45 billion into local bond and equity markets. Consequently, the rupee gained 1.76% during the month despite intervention.
RBI has used the forward market intensively to manage liquidity, outflows and the exchange rate at several times in the last four years. The most recent case was during the redemption of the foreign currency non-resident deposits. A few years ago, when D. Subbarao was governor, it used the forward market whenever an immediate impact of forex intervention on domestic liquidity was not desired. The extent of intervention using forwards increased during Raghuram Rajan’s tenure and continues under current governor Urjit Patel.
The reason for this increase in the central bank’s frequency and scale of visits to the forex market lies in a change in RBI’s liquidity stance. Under Rajan, the central bank had adopted the thinking that a liquidity deficit is best for transmission of policy rate changes onto market and loan rates. Now the stance has changed towards a neutral level of liquidity.
Given that the problem now is one of plenty, it makes perfect sense for RBI to rely on the forward market to prevent the rupee from appreciating sharply without adding to liquidity on an immediate basis.