RBI Interventions: Impact and Opportunities

There have been quite a few factors affecting the action in USD/INR spot and forwards in the last fortnight and are likely to continue to do so a while longer.

Firstly, Trump win followed by rise in US yields has resulted in outflows from the emerging markets stocks and bonds. USD 3Bn has been pulled out from domestic equities and debt combined since 9th November 2016.

 Secondly, Dollar shortage on account of FCNR (B) maturities has resulted in a crash in forward premia especially in the near months. The near November month in fact traded at a discount on Friday and December end premium was dealt at as low as 7p.

Thirdly, excess liquidity in the banking system on account of demonetization has also been responsible for the collapse of the forward curve as banks have been trying to deploy the Rupee funds by doing a USD/INR buy-sell swap. 

The banks have also mopped up huge quantities of government securities resulting in a fall in benchmark 10-year yield from 6.70% to 6.18% at a time when global yields have been rising. The benchmark 10-year yield touched its lowest level since 2009 and went below the repo rate for only the second time ever. The RBI has also accepted bids in variable rate reverse repo at a high cut off to support the yields and reduce the strain on banks. The far forwards did show signs of recovering especially after rumors that the RBI would mop up excess liquidity through MSS (market stabilization scheme). The ability of the RBI to mop up liquidity through MSS would have been constrained by its holding of government securities. Instead, the RBI chose to impose 100% CRR on incremental deposits raised by banks between September 16 and November 11 to sterilize the additional liquidity. Though demonetization was announced on 8th November, the RBI must have had an estimate of the amount that would enter into the banking system and with this ballpark figure it would have worked backward to arrive at the date i.e. 16th September.

It is important to dwell on the third point in the wake of RBI’s Saturday move as the markets will react to it in the immediate future. The immediate repercussion of this move would be severe on the money market, G-secs USD/INR forward curve and banking sector stocks. An unwinding is expected in the G-Sec market and a spike in yields is imminent. Money market yields are expected to spike more as compared to farther tenors as they are driven more by liquidity than rate expectations. The 10 year yield is also expected to rise but to a lesser extent as the rate cut expectations would still be in play. The far forwards (6-12 months) would also rise steeply, though the near end could remain under pressure a while longer on account of cash Dollar shortage.  The RBI has said that this is a temporary measure and that it would be reviewed on or before 9th December (most likely on 6th December during the bi-monthly monetary policy meet).The rationale behind this temporary move is to ensure financial market stability and to prevent distortions.The options that the RBI would be mulling would be MSS (market stabilization scheme) or CMB (cash management bills). Its decision would take into account factors including how quickly new notes come into circulation and what the withdrawal demand is likely to be for the new notes. In the coming few days the RBI would have a fairly reasonable estimate of the extent to which the increase in liquidity in the banking system is permanent.

As far as the spot is concerned, there is likely to be huge demand for Dollars at the RBI fix on Monday on account of exchange traded currency futures expiry. Arbitrageurs have taken advantage of the futures discount relative to OTC. During periods of low volatility, the futures generally trade at a 1-2 paise discount to the OTC forwards. The arbitrageurs therefore buy in futures (go long) and sell OTC forwards. On expiry, the open long futures contract gets squared off at the RBI reference rate (RBI fix). As a result there is a demand to buy Dollars in the OTC market at the RBI reference rate to square off the short OTC position. The RBI fix is traded in the market at par or premium or discount depending on the demand and supply to execute transactions at the RBI reference rate. During times when such arbitrage has played out, the RBI fix tends to trade at a premium.This time around; the open interest in near month November futures is USD 4Bn much higher than the usual USD 1.5Bn. The rupee could open weak and trade weaker till RBI fix on Monday. A rise in forwards could incentivize the exporters to hedge to take advantage of the elevated spot as well as forward levels. It will also be interesting to see if the RBI intervenes and supplies Dollars to stem rupee weakness.The RBI has been intervening in currency futures with the intent of curbing intra day volatility and also conserving FX reserves.

A large part of movement onshore is governed by what happens offshore in the NDF market. Due to regulatory restrictions pertaining to limits and underlying exposure, many foreign investors tap the overseas non-deliverable Rupee market to gain exposure to the Indian currency. When the sentiment is in favour of risk taking, overseas investors sell USD/INR NDF offshore to earn carry. During such times the 1 month NDF forward points trade at a discount of 6-8p compared to onshore 1 month forward points. However when the global sentiment is not in favour of risk taking, the risk averse investors unwind their short positions leading to a sharp rise in offshore points (Offshore points become higher than onshore points now). The peculiarity about USD/INR NDF markets is that it is pretty much driven by one sided flows i.e. short side flows. Therefore the reactions there are extreme. The movement onshore is tempered on account of opposite side flows and presence of RBI. As a result, the volatility onshore is relatively less.

Banks with offshore branches have been borrowing Dollars, doing a sell-buy and parking INR in reverse repo to make the most of the arbitrage opportunity.Due to the distorted overnight rates i.e. cash-tom and tom-spot on account of cash Dollar shortage, the banks not facing such shortage can exploit the arbitrage opportunity by borrowing USD overnight at LIBOR (pay 0.5%) and doing a sell-buy (at par) and parking INR in reverse repo at 5.25%.

With the forward curve expected to normalize, the exporters can reduce the maturity of hedges and park the hedges in near months and roll further when the forwards become attractive.

For example, consider a 1 year export forward contract booked with spot at 66 and forward points at 360 (30 points per month). The outright forward rate would therefore be 69.60. If the spot rate after a month is 67 and 11 month forwards points have fallen to 220 (i.e. 20 points per month) and are expected to normalize to 300 within a month (i.e. back to 30p per month), the exporter can cancel the original contract at 67 + 2.20 = 69.20 and book near month at 67 + 0.20 = 67.20. After a month if the forwards are back to the same level and the spot is at 68, the exporter can cancel the near month contract at 68 and reinstate the contract with original maturity at 68 + 3 = 71

Exporter’s Net realization value at maturity if he hadn’t stacked and rolled = 69.60

Exporter’s Net realization value at maturity if he uses the stack and roll strategy: 69.60 – 69.20 + 67.20 –68 + 71 = 70.6

In the first strategy the exporter receives a premium of 360p. In the stack and roll strategy, the exporter earns 140p (360-220) for 1st month, 20p for 2nd month and 300p for remaining 10 months totaling to 460p. The risk is to manage cash flow resulting on account of movement in spot on cancellation of existing contract.

Globally, the event calendar is packed for the next fortnight. We have the US November NFP, Italian referendum on constitutional amendment, UK Supreme Court verdict on government’s royal prerogative for invocation of article 50 to initiate Brexit negotiations with EU, ECB and BoE monetary policies, the RBI monetary policy and finally the FOMC.

The outcome of the Italian referendum on 4th December would be crucial for the Euro as the incumbent prime minister; MatteoRenzi has linked his political future to it. If the government loses the referendum, the risk of Italy exiting the EU would rise as none of the three major opposition parties are in favor of Italy staying in the EU.

If the UK Supreme Court upholds the high court’s verdict of Brexit negotiations to be routed through the parliament, it would avert a hard Brexit and would be positive for the Sterling. On the other hand, if the UK Supreme Court upholds the government’s royal prerogative, it would be negative for the Pound. The verdict is due between 5th and 8th December.

The US 10 year benchmark yield is expected to take a breather around 2.52% as the markets would wait for cues from the FOMC to recalibrate their expectations of the pace of future rate hikes. US Black Friday retails sales data and November NFP would be the other triggers.