India considers foreign exchange reserves as the key instrument to manage bond index inflows
The inflows would test the RBI’s strong hold on the rupee. Photo: Bloomberg
India’s vast foreign exchange reserves will be the first line of defense against market volatility stemming from an expected surge in inflows once the country’s bonds are included in global indexes, according to people familiar with the central bank’s thinking.
The Reserve Bank of India plans to absorb the inflows and match the outflows using its near-record high reserves of $642 billion, the people said, asking not to be identified because the discussions are private. While the direct impact of bond withdrawals is not a matter of immediate concern for the RBI, the central bank may consider adjusting its liquidity framework in the future and including currency intervention as an official tool if the large flows become persistent , the people said. Any adjustment will be a departure from the current policy where forex intervention is intended to smooth out volatility.
To manage domestic liquidity, the central bank will use available tools, such as a standing deposit facility, and may also consider other measures, such as asking the government to issue market stabilization bonds, the people said. Some measures are in the early stages of discussion and may not even be implemented yet, the people said.
JPMorgan Chase & Co. will include India in its emerging market bond index in June, with the firm estimating it could attract as much as $25 billion of inflows into the country’s debt market. Bloomberg Index Services Ltd. is expected to add India to its emerging markets index from January. Bloomberg LP is the parent company of Bloomberg Index Services, which manages indexes that compete with indexes from other providers.
The central bank expects at least one more index provider to follow suit by the end of June next year, the people said. FTSE Russell has already put India on its watchlist for inclusion in the emerging markets bond index.
India expects the credit rating of its government bonds is likely to be upgraded due to bond withdrawals, which will result in more foreign inflows into the country, the people said. Moody’s Ratings and Fitch Ratings Ltd. currently have India at the lowest investment grade level.
The inflows would test the RBI’s strong hold on the rupee, which is one of the least volatile emerging market currencies globally. Governor Shaktikanta Das has spoken out about the need to build foreign exchange reserves as a buffer against market sell-offs.
The central bank typically intervenes in the foreign exchange market to smooth out volatility, buying excess dollars when foreign inflows increase, thus preventing the local currency from appreciating too much. Reserves are being depleted by selling dollars and buying local currencies in the market to support the rupee when it comes under pressure.
Barclays Plc estimates that the monthly increase in reserves under Das has been higher than during the tenure of any other Indian central bank head. Das has not been averse to using reserves during periods of dollar strength, such as most of 2022, when reserves fell by $100 billion in about nine months.
Currency stability
The RBI is committed to maintaining the stability of the local currency in the face of rising inflows and in case of outflows due to sudden reversals, say people familiar with the RBI’s thinking. Despite its perceived heavy hand, the central bank still wants the domestic exchange rate to be determined by the market, the people said. While officials are aware that the rupee will strengthen, they will not let it move too far out of step with its peers, they said.
The Indian rupee is the best performer in emerging Asia so far this year. The currency fell 0.4%, compared with a 3-4% decline in the Indonesian rupiah and the Korean won.
However, the RBI’s intervention in the foreign exchange market has come into the spotlight. The International Monetary Fund called the RBI’s action “excessive” in December, implying that it was trying to influence the level of the currency. The US Treasury Department also previously listed India on its watchlist of potential currency manipulators.
Das has consistently defended India’s intervention policy, saying it acts as “an insurance policy against spillover risks” arising from central bank policies in advanced economies.
The RBI did not immediately respond to an email seeking more information.
Liquidity instruments
Any currency intervention could also pose a challenge to domestic rupee liquidity and will impact monetary policy aimed at curbing inflation.
To neutralize these flows, the central bank is likely to use the revolving deposit facility, first introduced in 2022, as its tool of choice to mop up excess liquidity build-up, one of the people said.
The SDF is a liquidity absorption period where banks can park cash with the central bank and earn interest 25 basis points below the RBI’s policy rate. The RBI does not have to put up collateral for this money, which creates the need for the RBI to hold more bonds. A relatively smaller liquidity increase or shortage could be addressed through the central bank’s reverse repurchase or floating rate repo operations, the people said.
To give investors the right interest rate hedging tools, the central bank is also considering introducing more complex derivatives products, the people said. It also expects a spike in volume from existing ‘plain vanilla’ hedging instruments, such as interest rate futures, they said.
First print: May 16, 2024 | 1:36 PM IST