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Why is the RBI buying dollars aggressively?

Foreign exchange reserves have risen by $50 billion since the beginning of the year, despite a net ~ $14 billion outflow from domestic equity and debt markets in the same period.

July 12, 2020 / 08:18 AM IST

RBI’s foreign exchange (FX) reserves crossing the half a trillion dollar mark created headlines recently. The RBI has been on a reserve accumulation spree. Its FX reserves have risen by $50 billion since the beginning of the year, despite a net ~ $14 billion outflow from domestic equity and debt markets in the same period.

FX reserves had risen for seven successive weeks until the week ending 12th June. We first analyse the impact that FX purchases have had on the exchange rate in Real Effective Exchange Rate (REER) terms, volatility in USD/INR, liquidity in the banking system, and RBI’s balance sheet.

Impact on Relative Performance of Rupee

The Rupee has been the worst performing Asian currency year to date. Two charts below help explain the price action in Rupee, relative to other Asian currencies.

Rupee IFA

When all the Asian currencies were under the pump due to risk aversion and flight to safety, the Rupee was the worst performer.

However, during the last one month, with improvement in global risk sentiment, while the other Asian currencies have been able to recoup their losses to a great extent, the Rupee has not been able to do so.

The RBI has used bouts of overall global dollar weakness to absorb inflows, thereby preventing the rupee from appreciating. This is reflected in the REER of the rupee.

The overvaluation of the rupee in relative terms has corrected by almost 3 percent since the beginning of the year.

Impact on volatility in USD/INR

Despite the rupee being an underperformer, the RBI has managed to contain the volatility in the rupee. Its intervention function has been asymmetric.

Though the RBI has been more aggressive in preventing the rupee from appreciating, it has intervened to prevent runaway depreciation in the rupee as well. We saw this recently when USD/INR spiked on flare up in India-China border tensions.

Impact on banking system liquidity

Persistent FX Purchases by the central bank has contributed towards keeping the liquidity in the banking system in surplus. The surplus liquidity in the banking system continues to hover around the Rs 6 lakh cr mark.

Surplus liquidity has aided in monetary policy transmission. It has kept the operating Rate closer to the Reverse repo rate. Money market rates have softened by all metrics.

Impact on RBI economic capital
One of the theories behind the aggressive reserve build-up by the RBI pertains to the economic capital framework.

Given the government’s stressed finances, the theory postulates the idea of the central bank using the strength of its balance sheet to help the government tide over the financial stress resulting from current unprecedented times.

(The author is Founder & CEO, IFA Global)

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Moneycontrol Contributor
Moneycontrol Contributor
first published: Jul 12, 2020 08:18 am