RBI in prisoner's dilemma in FX/rupee; NRI bonds way out?

Moneycontrol Bureau

The Reserve Bank of India appears to be in a bind over the options at hand to shore up the sagging rupee.

According of Bank of America Merrill Lynch economist Indranil Sen Gupta, the RBI may have no option but to raise dollars from non-resident Indians like it did in 1998 and 2001 through the Resurgent India Bonds and India Millennium Deposit respectively.

“We continue to believe that the RBI will have to recoup FX reserves rather than hike rates, to restore confidence in the INR (rupee),” says the BofA Merrill note.

Sen Gupta is of the view that the RBI needs to urgently buy forex to boost its import cover (measured as the number of months of imports foreign reserves could pay for), which right now down to roughly 7 months; below the optimal range 8-10 months. The trouble is that buying dollars would strengthen the US currency and further weaken the rupee. Yet Sen Gupta feels the rupee is unlikely to stabilize till RBI bolsters its FX reserve.

Also Read: RBI tightens daily borrowing norms to douse rupee fire

Last week, in a bid to support the rupee, the RBI raised interest rates indirectly by reducing availability of short term funds to banks. This was done to reduce money in the system that could be used to punt on the dollar.

The flipside of this strategy is that it will cause interest rates to shoot up and hurt economic growth.

Here is the math, according to Sen Gupta: Higher interest rates may attract FII money into debt. But the FII debt portfolio is just USD 30 billion. But concerns over economic growth would rattle FIIs investing in equity. And that is a big risk because the FII equity portfolio is around USD 250 billion.

Excerpts from the Merrill report:

"There is acknowledgement that FX reserves are no longer adequate. Our BoP estimates do not suggest the RBI will be able to buy FX beyond USD 7.5 bln, which will just about extinguish its USD 5 bln FX forward book."

"To restore a level playing field for the INR relative to other currencies, the RBI will have to raise some lumpy capital inflows. The current policy of attracting capital inflows via hikes in FII debt limits is running into rough weather as fears of Fed tapering spark a selloff of emerging market debt. Proposals to hike foreign direct investment limits - telecom is done - or FII equity limits in public sector banks could also attract capital inflows but only in the medium term.

In our view, the best policy option at this stage is to issue a NRI bond like the 1998 RIBs or 2001 IMDs, which could raise about USD 20 bln or sovereign bonds, which could mobilize USD 5-8 bln a year."