Why the RBI can only watch while the rupee slides against the dollar

The Reserve Bank of India (RBI) recently coined a new term for money printing, calling it the government-securities acquisition programme or G-SAP. In the three months to June, the RBI plans to buy government securities worth ₹1 trillion. The RBI will have to print money to buy these securities.

The government sells bonds to fund its fiscal deficit or the difference between what it earns and what it spends. These securities are referred to as government securities.

The RBI governor Shaktikanta Das made the G-SAP announcement on 7 April as part of his statement accompanying the latest monetary policy. Since then, the rupee has been losing value against the dollar. On 6 April, a dollar was worth ₹73.28. As I write this on the morning of 14 April, it is worth ₹75.2. The rupee was weakening against the dollar even before that. One dollar was worth ₹72.45 as of 29 March.

This fall has come after the dollar was worth between ₹72-73 through much of 2021.

So, why is the rupee losing value against the dollar now, after remaining stable through much of 2021?

In the long-term, it has been observed that the rupee loses 4-5% against the dollar every year on an average. This is because the inflation in the US is much lower than that in India, and hence, the dollar-rupee exchange rate needs to adjust for that.

But this doesn’t happen like clockwork every year, and there are short-term reasons for the rupee losing value. Let’s look at them pointwise.

1) A simple explanation for the rupee losing value lies in the fact that the RBI plans to print money. The RBI will conduct the first round of purchase of government securities worth ₹25,000 crore on 15 April. The money to buy these securities will have to be printed. This means there will be more rupees in the system than before, and hence, the rupee is losing value against the dollar.

2) This would have been the perfect explanation but for the fact that RBI has been printing money and buying bonds, even before the recent G-SAP announcement. The G-SAP announcement was a formalization of what the RBI has already been doing through ad hoc open market operations. From January to March, net-net, the RBI printed money and bought bonds worth ₹79,700 crore. So, why did the rupee not lose value through January to March, as it has been doing in April?

The answer lies in the fact that the RBI, in its recent statements, has made it very clear that it is batting for the government and will do whatever it takes to keep yields or returns on government securities low. This was made clear to the bond market by Das’ statement on 7 April and in the lead article in March’s monthly bulletin.

The yield on government bonds is the annual return an investor can earn if he buys the security on a given day at a certain price and holds on to it until maturity.

To keep the returns on government securities low so that government can borrow at a low cost, the RBI will have to ensure that there are enough rupees going around in the system. And for this, it will have to keep printing money.

On the other hand, the return on American government bonds has been going up since early February. If this continues, it means money will leave India and go to the US. This will mean an increased demand for the dollar. The foreign exchange market is adjusting for this possibility and driving down the value of the rupee.

3) Now, let’s look at the excess money in the banking system. This can be gauged from the total amount of money that banks have no use for, and they deposit it with the RBI at the end of the day. This had stood at ₹6.64 trillion as of 1 January. It had fallen to ₹3.8 trillion as of 31 March. This means that banks were lending out more money and hence, depositing a lower amount of money with the RBI. This can be gauged from the fact that the loans outstanding of banks grew much more in the first two months of 2021 than they did during the period April to December 2020.

Things have changed since 31 March, with the excess money in the banking system growing to ₹6.26 trillion as of 11 April. What does this tell us? It tells us with the second round of covid spreading fast throughout the country, the lending by banks is slowing down.

In this environment, if the RBI prints more money, the excess money in the banking system will only go up. The chances of the RBI continuing to print money after the first round of G-SAP ends in June remain high.

The reason for this lies in the fact that the government has plans to borrow an excess of ₹12 trillion for the second year running. Also, with covid spreading all over again, the tax collections are likely to remain subdued. Hence, the borrowing by the central government and the state governments will continue to remain high.

As the debt manager of the government, the RBI needs to make sure that the government can continue borrowing money at low rates of interest. This can only be done by ensuring that there is no shortage of rupees in the system, for which the RBI will continue printing money and buying bonds.

Hence, the glut of rupees in the system is likely to continue. The market is discounting for this possibility, leading to the rupee losing value against the dollar.

4) In the normal scheme of things, when the rupee is losing value against the dollar, the RBI can intervene in the foreign exchange market. It can do so by selling dollars from the hoard of foreign exchange reserves that it has and buying rupees. In the process, the excess rupees in the system will be sucked out, and the rupee will stop losing value against the dollar or lose value at a slower rate.

But there is a problem this time around. The RBI wants to ensure that there is a glut of rupees in the system so that the government can continue borrowing at lower interest rates. By intervening, it will suck out rupees from the system, something it doesn’t want to do. Hence, it’s caught up within the devil and the deep sea. There are news reports that suggest the RBI is intervening in the foreign exchange market to attest to the fall of the rupee, but as mentioned earlier, its ability to do remains limited.

5) Also, with the rupee appreciating, the carry trades are unwinding. A carry trade involves borrowing money in a currency in which interest rates are very low (as is the case with much of the rich world currently) and investing it in a currency where interest rates are on the higher side (like the rupee).

The thing that can jinx this trade is the depreciation of the currency in which money is invested. As the currency in which money has been invested loses value, the total amount of money that an investor makes in the currency he has borrowed goes down. To avoid this possibility, investors unwind the carry trade. In the current context, this would mean selling rupees and buying dollars, leading to a further depreciation of the rupee. News reports suggest that this is currently on.

As ironic as it may sound, the covid pandemic may come to RBI’s rescue on this front. As happened last year, when the pandemic spread, imports collapsed faster than exports. This meant that the demand for dollars wasn’t much, at least when it came to imports. Something like that might happen in the months to come if covid keeps spreading. This will mean lower demand for the dollar to pay for imports, putting rupee lesser pressure on the rupee in the downward direction.

In the short-term, with the focus being on continuing to help the government borrow at low-interest rates, the RBI should be comfortable with the rupee losing value and letting the dollar touch ₹77-78.

Vivek Kaul is the author of Bad Money.