Why India is flooded with foreign funds RBI Currency Strategy

What has happened?

The reserve bank of india’s strategy to shift some of its currency intervention to the forwards market is adding to its problems. It’s balancing act to keep the rupee stable amid heavy foreign inflows while also keeping excess liquidity in check is flooding the market with more foreign funds, prompting a vicious cycle of interventions.

The RBI’s outstanding forwards book grew to $28.3 billion as of november from a negative $4.9 billion in the fiscal year 2019-20, highlighting the extent of its operations.

That’s pushed the 12-month implied yields, which typically reflect the interest rate differential between india and u.s., to the highest in more than four years, fuelling further inflows.

How RBI intervene in currency market?

The RBI’s currency intervention works like this — it buys dollars in the spot market to prevent sharp gains in the rupee.

It then sells these dollars in the forwards market to offset the liquidity impact.

Spot vs forward

In currency markets, the spot rate, as in most markets, refers to the immediate exchange rate. The forward rate, on the other hand, refers to the future exchange rate agreed upon in forward contracts.

For example, if an indian electronics manufacturer has a large order to be shipped to america in one year, and expects the u.s. dollar to be much weaker by that time, it might be able to transact a currency forward to lock in a more favorable exchange rate.

Vicious cycle

Speculators are gravitating to short the u.s. dollar and buy rupee due to the high forward premium.

In order to prevent speculators from taking the rupee higher, the RBI is being forced to buy more dollars in the forwards market, which is pushing premia higher. This is a vicious cycle.

So what is the problem if more funds are coming SIVUYT

First of all these are not productive funds and are her for short term. Second, the increase in yield will lead to increase in interest rate which is not good for growth.

What RBI said on this?

The central bank will act on forward premiums when necessary, RBI governor shaktikanta das said last week. “we are very watchful of the forward premia rates“he said.

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