Everyone knows RBI is buying dollars in the spot market to keep the rupee from appreciating much. But few people know is that RBI has also piled up a lot of long dollar positions in the forward market.
RBI data shows the central bank’s long dollar positions in forwards, stood at 73 billion dollars as of end-March 2021 from a short position of about USD 5 billion dollars a year ago. Also, RBI has been paying high premiums of over 5.25 percent for one year forward dollars for the past few months, although one year T-bills (Treasury bills or government securities) yields are 3.7-3.8 percent.
Last week these premia fell from 5.25 percent to 4.3 percent. My effort to get some details from RBI on why the premia fell was met with a terse, “all transactions of RBI is spot and forward market are to manage inflows and outflows.”
Another set of questions have arisen over the high gross sales and purchases of dollars in the spot market by RBI from Jan- March this year and whether this is connected with RBI’s high dividend.
“The dividend was higher because the provisioning was lower” is the central bank’s response to this question.
Since RBI hasn’t divulged any details, the following is an effort to flag the puzzling questions in the market and plausible answers, guessed by traders. Some answers may be approximate guesses, and I hope these will elicit a discussion between market experts and we may arrive at better guesses.
Q: First up, what is forward premium?
A: A forward dollar transaction is a commitment by a party to buy say 100 dollars one year later from a bank. Now that bank has to book 100 dollars for delivery one year later. Dollar earns an interest of about 0.25 percent for one year. But if the same bank were to keep the same amount in rupees, it would earn at least 3.75 percent (one year T-bill yield).
For sacrificing a higher interest rate, the bank charges the buyer a premium, related to the difference in interest rates between dollar and rupee for the same tenor.
Q: So what was intriguing about the prevailing forward premium?
A: The one-year forward premium, for instance, has been at over 5.25 percent for several months while the one-year T-Bill yield has been ranging between 3.5-3.75 percent.
Q: Why has RBI’s forward dollar positions risen so much, from a short position of 5 billion dollars one year ago to a long position of 73 billion dollars in March?
A: Currency market experts have two theories for this.
One, there has been a huge inflow of dollars and little demand for them for many reasons: There is a rush of dollars to buy emerging market (EM) equities including that of India. Foreign Direct Investment (FDI) has been high. Indian exports are doing well because destination economies are growing, but imports have been weak because the domestic economy is in lockdown. All these inflows means the rupee will appreciate and make Indian exports uncompetitive.
So, to keep the rupee in check, the RBI has been buying dollars, which means it injects rupees into the banking system. (The RBI has also been forced to buy government bonds to keep yields low) Very high banking liquidity can lead to misdirected lending and inflation. So, RBI buys dollars in the spot market and then does sell-buy swaps so that it has to take delivery of the dollars (and hence inject banking liquidity) at a later date. This is one reason for the high quantum of forward dollar positions held by RBI. It is postponing the injection of liquidity into the banking system
Two, as Professor Ananth Narayan argued in his Observatory papers and on CNBC-TV18 last week, spot USD purchases by RBI would have expanded RBI's balance sheet, while forward USD purchases helps avoid such an expansion.
Now the Jalan committee has stipulated that the RBI needs to keep a minimum economic capital of 20.8-24.6 percent of its balance sheet. If the $73 billion of RBI forward USD purchases as of March 2021 had been spot purchases instead, they would have formed part of RBI's FX reserves, and RBI's balance sheet would have closed higher by about Rs 5.3 lakh crore. That in turn would have required RBI to maintain additional provisions of Rs 1.1 lakh crore. Its surplus transfer to the government would have been zero. Some experts wonder if this was a consideration in RBI's very high forward purchases, despite the very high cost as implied by the high forward premia?
Q: Now the important question. Why are forward premia so high? Shouldn’t banks be stepping in to arbitrage the difference between forward premia and money markets?
A: The lack of liquidity in the forward premium market has come about after a “large exposure framework” rule that came into effect in 2019. Under this rule, a bank’s exposure to all counterparties is capped at 25 percent of its capital. For Indian branches of foreign banks, exposure to their own parent is capped at 20 percent of Tier 1 capital. (This rule was intended to make foreign branches disciplined: for example, assume some banks had been giving high guarantees to their clients on the strength of their foreign head offices, now if the foreign entity collapses, the Indian unit’s guarantees won’t be honoured). However honourable the reasons, this has put a limit to foreign banks’ ability to receive forward dollar positions from Indian banks, and this is one big reason why premia on forward dollars have shot up and are out of sync with rupee interest rates.
Separately, RBI’s forward dollar positions, as we noted, have become so high, that premia would have moved higher anyway. Only they got more skewed because of the large exposure rules.
Q: Why did the premia fall in the first week of June?
A: Firstly, they were so high that some fall was likely. Secondly, the RBI also took delivery of some forward dollars, when the transaction fell due. Data released on June 1 by RBI for end-April showed a 7-8 billion dollar fall in RBIs forward positions versus its March-end levels.
Q: Why did the RBI suddenly take delivery and run down positions?
A: The RBI did not answer my question when I asked in the press conference.
Maybe it wanted to surprise the market. Maybe it is less scared of high liquidity causing inflation now. Or it is the unspoken reason: the pressure to keep balance sheet smaller (and declare higher dividend) was more pressing on March 31, the date on which the capital is calculated. This pressure abated in April.
Q: Our other question at the start: Why are RBIs gross sales in January, February and March this year so abnormally high?
A: Note this table
*9-month year for RBI
RBI has sold in FY21, 3 times the amount of dollars it sold in FY20, in what’s a 9-month financial year for it. Also, 75 percent of the 85 billion dollars was sold Jan-March. Also in these three months, RBI purchased almost equivalent amounts so the net spot position was zero. This leads to the suspicion that RBI was selling dollars to generate profits to pay a dividend to the government. In fact, RBI recognized Rs 50,000 crore of 'exchange gain from foreign exchange transactions during July 2020 -March 2021, while this sum was at about Rs 30,000 crore in the two previous full fiscal years.
Q: Taking from the previous answer, how can RBI make profits if it sells and buys back the same amount of dollars?
A: This is because, after the Jalan committee recommendations of 2019, the RBI uses the historical weighted average acquisition price of dollars to calculate gain or loss when it sells dollars. So if RBI buys one dollar in the spot market for 73 rupees and sells one dollar for the same price on the same day, it will still show a profit.
Here’s how the accounting works: because it has bought dollars all the way from say 45 rupees, its average historical purchase price of dollars will be quite low. Assume it is Rs 60. So when it sells a dollar for Rs 73, it makes a profit of Rs 13. The one dollar it buys for Rs 73, will increase its historical purchase price of dollars by a wee bit. Experts like Ananth Narayan suspect RBI may have used this accounting crack in the door to recognizing exchange profits to increase its surplus.
Q: So can RBI continue to declare such large dividends?
A: No says, Citi Economist Samiran Chakrabarty. This year, RBIs balance sheet is growing because it is buying a whole lot of government bonds and dollars. So it will have to keep more capital next year. Also if the rupee appreciates, RBI’s capital decreases and it will have to transfer more income to reserves. Others also point out that If RBI keeps on selling dollars and buying in the spot market, its historical acquisition price will keep rising and so the extent of surplus falls.
Q: What does this mean to the economy, to you and me?
A: High forward premia, out of sync with rupee rates is a distortion of the market and is unhealthy. It creates unnecessary speculative trades.
Secondly, a central bank intervening in the market to curb too much volatility or speculation is fine. But a central bank acting as a trader to make a profit for its owner may reduce its credibility. Next time, the country faces problems in the FX market, RBI’s intervention may be less effective because traders will look for motives.
Thirdly and most important is the huge dividend by RBI. All purchase of bonds and rupees and surplus payment to government is money printing by RBI. If RBI prints much more money than the increase in goods and services in the economy, it will create inflation. Today since the economy is in a funk, and there is excess capacity and less activity, this money creation is okay. But once the economy picks up, we could suddenly see double-digit inflation.
So all these happenings in the foreign exchange and money markets and these fantastic dividends to the government can one day come back to bite.
First Published: IST