RBI’s Studied Silence Over External Vulnerabilities

Critics are questioning the wisdom of the RBI after a 25 basis point reduction in benchmark interest rates fell short of capital market expectations

The Reserve Bank of India’s (RBI) 25 basis point reduction in benchmark interest rates fell short of capital market expectations. They were expecting a deeper cut but the Monetary Policy Committee (MPC) played safe, given uncertainty surrounding the future inflationary path. Critics are questioning the wisdom of the central bank and its MPC.

MPC members surely deserve to be cut some slack. But, in the general din over low food inflation, insufficient interest rate cuts and RBI’s unchanged neutral policy stance, the central bank’s policy statement omitted mention of a small crimp: a tsunami of portfolio flows, another possible source of inflationary pressures. The central bank’s studied silence about external vulnerabilities raises many questions.

This rush of foreign currency has forced RBI to take steps which have disappointed overseas debt markets and investors: for instance, rules have been tightened for issuing masala bonds through introduction of maturity floors and interest rate caps. This comes when masala bonds were gaining popularity with both issuers and investors. In another (though seemingly unrelated) circular, the RBI has sought to elongate the maturity profile of investments by foreign portfolio investors (FPI) in government bonds. Capital markets regulator, Securities and Exchange Board of India (Sebi), followed through with another circular, ordering a temporary stop to future masala bond issuances.

The RBI has probably sensed higher risk—in terms of both rates and exposures—in the opening of masala bond floodgates, especially after offshore arms of certain Indian companies raised foreign currency loans in overseas markets and then on-lent the proceeds to domestic entities as rupee bonds. This structure defeats the entire purpose of shielding Indian borrowers from exchange rate volatility since it provides original lenders with an indirect claim on domestic assets.

Sebi’s rationale is that FPI investments in corporate bonds have reached close to the limit of Rs244,323 crore. This ceiling includes all rupee-denominated bonds, offshore or on-shore. The regulator’s circular also states that masala bond investments can resume only after limit utilization falls below 92%.

RBI’s rear-guard action also probably stems from the combined effect of two other reports—its own report on India’s external debt and the annual External Sector Report from the International Monetary Fund (IMF). Both sound circumspect about India’s rising short-term foreign debt levels. The IMF reports states: “Given that portfolio debt flows have been volatile and the exchange rate has been sensitive to these flows and changes in global risk aversion, attracting more stable sources of financing is needed to reduce vulnerabilities… Further initiatives on creating a more conducive business environment, particularly the implementation of long-standing labour market and power sector reforms, are necessary to attract greater FDI flows.”

FPI investments in equity and debt markets saw combined net inflows of Rs171,581 crore till July end. This is six times more than the Rs27,055 crore invested by FPIs during the same period of 2016. This surge had rupee appreciating by almost 5.8% between 2 January and 31 July.

Such large inflows put RBI’s absorption skills to the test. First, it has to intervene in the foreign exchange market to absorb foreign currency inflows so that portfolio investments do not push up the rupee-dollar rate beyond its sustainable and economic value. The resultant overhang of rupee liquidity then requires a second defensive action: the RBI has to mop up liquidity through a variety of instruments. For example, in the 11 working days between 17 July and 29 July, RBI absorbed Rs405,228 crore. Sterilization has its costs, especially when central banks sell high-yield domestic instruments while buying relatively low-yielding foreign currency assets. There are also fiscal implications.

The central bank’s woes do not end here: it needs to calibrate another two-step dance. The RBI’s remonetization exercise is still far from complete but it is unable to accomplish that at full tilt, given the wash of domestic liquidity. At the same time, it has to ensure that there is enough liquidity to make up for lost productivity during demonetization. Both will require precision and fine-tuning. Plus, it needs to ensure there’s just enough liquidity to keep yields soft.

There’s another dilemma. The FPI investment limit in corporate bonds was fixed when the exchange rate was below Rs50 to a dollar and common sense dictates a re-calculation of the limit. But the central bank is not doing that just yet, given that its hands are full trying to staunch current inflows.

Times like these are ripe for conspiracy theories. There are misgivings that RBI’s efforts could be an indirect attempt to ensure borrowers do not export the domestic bank credit market to offshore centres. While bank credit growth remains anaemic, Bloomberg data shows Indian companies raised $8.9 billion through overseas bond sales till July, 63% higher than the previous year. It is believed many companies took advantage of tightening spreads and used foreign currency bond sales to refinance domestic bank exposures, thereby intensifying balance of payments risks.

The MPC statement omits mention of external sector developments. Hopefully, the RBI will separately provide a more comprehensive communication that details the risks and the mitigation measures.

The article originally appeared in Mint newspaper on August 9, 2017, and can also be read here