An article by Soumya Kanti Ghosh on the likely CRR cuts

1. CRR CUTS IN MARCH LIKELY
Director
Economics & Research, FICCI
As published in The Financial The news on the Indian economy is not getting better. First, it was the news of sub-7%
Express; February 28, 2011 GDP growth in the current fiscal and now the December IIP numbers coming as another
http://bit.ly/Aya43X shocker. However, what has been really surprising is the dramatic pull-back in rupee
value in January 2012. After touching a low of of 54.23 on December 15, the rupee
touched 48.7 on February 6. While analysts have quickly attributed the recovery in
rupee value to the resurgence in portfolio capital flows (cumulative portfolio flows from
December 2011-February 6, 2012, is now $11billion), we feel that smart move by RBI, of
changing track and intervening in the forward exchange market, did the trick.
First, a little trivia. The demand for the dollar in the forward market always acts as a
leading indicator of an exchange rate crisis. Subsequently, the slide in the rupee value
beginning August 2011 was waiting to happen with the demand for dollars in the
forward market beginning to build up in both the merchant segment and interbank
segment from June 2011 onwards (see table). For example, the excess demand for
dollars in the merchant segment of the forward market crossed $11 billion in September
2011 from $429 million in June 2011, only to decline to $9.5 billion in January 2012 on
the back of RBI currency supportive measures.
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2. How do we explain this excess demand in the forward market? Simply, in an
environment of rupee depreciation, the exporters typically adopt a wait-and-watch
attitude with regard to bringing in export proceeds from abroad. This pushes down the
supply of forward dollars. On the other hand, the forward demand for dollars is
magnified during times of forex market crises in both the merchant and interbank
segment. In the merchant segment, the demand is because of a rush by importers and
the like to cover unhedged positions (excess demand for forward dollars crossed a
staggering $11 billion in September 2011 from a negative $429 million in June 2011). In
the interbank segment, the mad rush is because banks typically go long on forward
dollars with the idea of making profits (from $3.53 billion in June 2011 to $5.7 billion in
September 2011).
Clearly, the speculation by market players under the current circumstances only
hastened the fall in rupee value. This situation has also been aggravated at times by
extraneous factors, like payment for Iran’s oil bill and defense purchases being made
from the domestic markets and perhaps resulting in market players scrambling for
forward cover of their dollar liabilities on the expectation that the demand supply gap
may worsen further.
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3. Now, the masterstroke by RBI. As Exposition 1 shows, RBI smartly changed track and
intervened in the forward foreign exchange market in November 2011 after a gap of 12
months. Even though there is an enormous amount of economic literature on spot
market interventions by central banks, there is little on forward markets. One possible
reason for this could be that the forward market interventions (typically swap
transactions, buy-sell or sell-buy swaps, outright forward purchase/sales) are typically
construed as an example of secret interventions; that there are no official reports of
intervention, even though the central bank indeed intervened.
Interestingly, in the 1950s and early 1960s, there was considerable debate on the
efficacy of the forward exchange market initiated by John Sparos, which is still relevant
today. Going by John Sparos, the best way to fight currency speculation is to
deliberately let the forward premia rise to unreasonable levels and thereby penalise the
currency speculators as their exchange rate expectations about a depreciating domestic
currency are belied. Alternatively, if there is a depreciation of the domestic currency in
the spot and the forward market, then the authorities must sell the foreign currency in
the spot market (that is leaning against the wind), whereas the authorities must
deliberately purchase the foreign currency in the forward market (leaning with the
wind) in order to penalise the speculative players in the forward exchange market. We
call this policy in the forward exchange market the Sparos effect, and it is precisely the
Sparos effect that turned the tide for the rupee. This is how it did it.
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4. Consider Exposition 2. RBI was a net seller to the extent of $1.62 billion in the forward
market in November 2011. We believe a part (possibly significant) of this forward sale
was perhaps a sell-buy swap (selling spot dollars in exchange for domestic rupee
resources and buying them forward). This is because RBI may have avoided outright
forward market purchases, given that the central bank may avoid draw-down of foreign
exchange reserves (faced with the the prospect of a strain on the same by June 2012).
As the figures for November 2011 shows, the gross sale of forward dollars was $1.62
billion during the month. Since there was a significant increase in forward premia
(across all spectrum) in November 2011, it is clear that such a transaction was primarily
a sell-buy swap. Most importantly, such sell-buy swaps worked, as they immediately
pushed up the forward premia in November 2011, leading to rupee appreciation in
subsequent months.
Clearly, the RBI strategy has worked in this case. The advantage of these swaps is that
they merely change the composition of foreign change reserves and hence are another
way of sterilising capital inflows. However, there are disadvantages, too. If the foreign
exchange market is fairly thin, the use of foreign currency swaps for sterilisation only
adds volatility to the forward market. Interestingly, as RBI puts it, forward sell-buy
swaps, even when undertaken on a large scale, do not have lasting impacts in correcting
distortions in forward premia. Also, the cost of swaps, as captured in the accounts of
RBI, has increased with the appreciation of the rupee. In the end, even after
acknowledging the limitations of swap transactions, they have worked, with portfolio
and export proceeds picking up enough steam post November 2011 (see exposition 2).
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5. This, perhaps, has been the most significant gain in 2012! However, a word of caution.
Any sell-buy swap when it unwinds will be followed by forward transactions to
neutralise the former (in December 2011, the official data shows that there were $250
million forward purchases), and subsequently, there may be an increase in the volatility
in rupee. As Exposition 3 suggests, the volatility in the rupee value, which declined
significantly from end-Dec ember 2011 has started to increase again, that portends bad
for the market.
Finally, as the data suggests, there has been a liquidity withdrawal of nearly R55,000
crore during November-December 2011, because of foreign exchange market
interventions. This perhaps sets the perfect recipe for another round of CRR cuts in
March 2012, to offset such a negative impact.
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