The Indian rupee (INR) is under the vigilant supervision of the Reserve Bank of India (RBI), which focuses on maintaining stability and curbing volatility. While effective in the short term, this strategy also has its complexities and potential long-term consequences.
The RBI’s unwavering commitment to keeping the INR stable has been a cornerstone of its monetary policy. By mitigating the impact of external factors such as portfolio flows and changes in the economic outlook, the RBI has successfully kept the INR in check. This low volatility environment helps improve the carry profile of the currency, allowing for a narrower interest rate cushion and reducing the need for currency hedging, despite the low costs this entails.
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However, this extended period of low volatility could hinder market price discovery and create a backlog of hedging demand when the volatility regime eventually changes. Moreover, the RBI’s strategy of building foreign exchange reserves by absorbing capital inflows could lead to a gradual depreciation of the INR over time.
The continued low volatility of the INR is a direct result of the RBI’s efforts to maintain stability. By controlling spikes in currency volatility, the RBI aims to decouple its monetary policy decisions from external influences. This policy has left portfolio flows to India largely unhedged, despite historically low hedging costs.
However, this stability comes with its own challenges. The RBI may have gone too far in its attempts to control volatility, pushing it to levels similar to that of a pegged currency. Prolonged low volatility could hamper INR pricing and create pent-up demand for hedging. Furthermore, a gradual shift in the trading range has made it difficult for the market to exploit significant carry-ups as the lack of correlation with macro fundamentals continues.
One of the consistent policies of the RBI is the aggressive build-up of foreign exchange reserves. This strategy aims to create a buffer against future capital outflows. While the RBI has defended the INR against weakness, the risks of a policy shift are increasing. The need to unwind accumulated short forward positions while defending the INR around the 83.5/USD level could further shift risks towards a gradual depreciation, making the USD/INR pair more likely to be a buy-on -dip strategy will follow.
To understand the RBI’s intervention patterns, an analysis of key factors over the past decade shows that the RBI is most sensitive to portfolio flows, with inflows being absorbed into reserves on an almost one-to-one basis. This consistent correlation with portfolio flows is partly due to the broader relationship between USD movements and portfolio flows into emerging markets.
Another consideration is the INR’s competitiveness, especially in promoting domestic production and import substitution. Recent trade balance swings, driven by higher oil prices and wider deficits, have shown a stronger correlation with USD strength. The Real Effective Exchange Rate (REER) index for the INR has remained within a range over the past decade, although it is currently at the upper end of this range. Although the long-term appreciation of the REER may be justified by productivity gains, further appreciation may be undesirable from a policy perspective.
The RBI’s careful management of the INR has helped maintain stability, but it also poses challenges. As the RBI continues to build its forex reserves and deal with the complexities of maintaining low volatility, the potential for gradual depreciation of the INR remains an important consideration. This balancing act will be critical in shaping the future of Indian monetary policy and the INR’s trajectory in the global market.
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X (formerly Twitter) – Ayush Khanna
