The RBI did the unthinkable while clamping down on speculators playing the currency market. The rupee has been depreciating, and briefly even touched the psychological 95-mark against the dollar on March 30. The central bank’s traditional tools involving dollar sales in the spot and forward markets were not helping even after exhausting over $30 billion in March alone. So it decided to pull the plug on banks’ arbitrage trade, which involves buying dollars in Mumbai and selling them in Singapore, Dubai and London, where the dollar is priced higher, and profit from the difference. Per estimates, large domestic banks are running arbitrage trades in excess of $300-400 million. The RBI mandated all of them to reduce such exposures to $100 million by April 10. But the banks, instead of obliging, passed on the trades to corporates, importers and traders, forcing the regulator to issue follow-up orders on Wednesday to close all loopholes. Together, the measures may temporarily increase the supply of dollars and strengthen the rupee.
The question, though, is how long it will sustain the rupee’s slide. On Thursday, the rupee did strengthen to close at 93.10. But once banks unwind their dollar positions, and if global crude oil prices continue to scale past $100 a barrel, the pressure on the Indian currency will be unavoidable. If the weakness continues unabated, analysts believe that interest rate hikes to defend rupee is less likely. Instead, the RBI may re-introduce measures like foreign currency non-resident subsidised swap windows to attract NRI deposits. It may also tighten liquidity conditions, raise effective money market rates to make it expensive for speculators to short the rupee. Other tools in hand include the government stepping in with restrictions and higher import duties on gold and non-essential imports, the RBI offering a forex swap window for oil marketing companies to tap dollars instead of going to the market, and tightening remittance scheme limits.
The central bank should stand ready to implement some of these measures, as clearly, the traditional forex interventions seem to have reached their acceptable thresholds. Controlling the rupee’s weakness is paramount for the RBI’s overall policy objectives including inflation forecasts. Its own models show that every 1 percent weakness in the rupee firms up inflation by 7 basis points. Even if pump prices remain unchanged for now despite higher global crude prices, the threat of anchoring inflation expectations needs to be closely monitored.