Whither Exchange Rate Policy?

(Amount in $ million)

tion, is clearly out of

countries have adopted

-5,000

-10,000

ing the rate of change

Exchange Rate Amount in $ million 14,000 –

11,000 –

8,000 –

5,000 –

Fedai Rates

2,000 –

-1,000 –

-4,000 –

-7,000 –

-10,000 –

-13,000 –

Net Foreign Currency Purchases (+)/Sales(-)

-16,000 –

Table 2: Money Market Operations (RBI’s Daily Data)

Average

fluctuations. Third, a

Amount in rupees

– 47

nomic growth, which

– 49

were important in the

– 51

earlier days. In the light

– 53 of volatility induced by

1/09 3/09 5/09 7/09 – 55 capital flows and the

1.1 Nuances of Exchange Rate Policy

Y V Reddy in his famous speech of 1997 on

ment postulated the main objective of India’s exchange rate policy as to ensure that economic fundamentals are reflected in the external value of the rupee. Subject to this predominant objective, the conduct of exchange rate policy was guided by three major purposes: to reduce excess volatility, ensuring that market corrections are orderly and calibrated; to help maintain an adequate level of foreign exchange reserves; and, to help develop a healthy foreign exchange market. The nuances of India’s exchange rate policy were further shaped by Bimal Jalan through several of his statements between 1998 and 2003. The broad principles that have guided exchange rate management in this period were:

These nuances in policy mostly continued through Y V Reddy’s period of governorship and his parting July 2008 statement summed up these broad principles.

1.04-3.32 2.25-3.23 2.24-3.18

Data for reporting Fridays are given within brackets and they are also included in the weekly range/daily averages. (RF): Reporting Fridays . $$ No of reporting/traded days are fewer than given above.

MONEY MARKET REVIEW

Subbarao acknowledged this stance in his first October 2008 statement indicative of status quo in the nuances of exchange rate policy. But, in his latter statements of January, April and July 2009, while he retained the portion relating to management of foreign exchange reserves, he has kept silent in so far as exchange rate policy is concerned.

1.2 Differing Policy Views

A number of suggestions have been made from time to time calling for a shift in the RBI’s exchange rate policy. One strong recommendation made by S S Tarapore in 1997 in his first report on convertibility, which he reiterated in his second report of 2006, is that the RBI should attempt to follow a policy of maintaining a real effective exchange rate (REER) band which is tantamount to a fixed target within a wider band. The RBI, while acknowledging that REER could be an indicator from a medium-term perspective, refrained from using it for managing short-term rate movements. In the last two years, it should be added that the REER, as a measure, has lost its efficacy because of considerable divergence in inflation measures as depicted by the Wholesale Price Index (WPI) and the Consumer Price Index (CPI). As the REER formula adopted by the RBI uses WPI to measure Indian inflation and CPI to measure other countries’ inflation, the inflation differential as captured by this formula cannot be considered any more representative and studying REER trends based on recent data could give a distorted picture. Furthermore, since India moved away in practice from targeting rates, there is no question of revival of targeting an REER band.

Another view that found support among some prominent economists, including Kenneth Rogoff, is that rupee should be allowed to appreciate freely in line with market trends. According to this view, there is no strong case for the RBI’s further intervention as reserves are already very high. The RBI’s purchases create substantial additional domestic liquidity, which may be destabilising in the long run. All indications are that improvements in productivity and profitability in Indian businesses have been deep enough for exporters to withstand the kind of appreciation we

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August 22, 2009

have seen. Secondly, Graph C: Trends in Weighted Averages of Call Rates, Repo Rates and CBLO Rates – July 2009

intervention in the forex 3.5 – market has become very

difficult in the face of the kinds of inflows we 2.5 are facing. It leads to a

huge injection of liquid-1.5 ity which fuels inflation.

Rupee appreciation, in contrast, is a useful 0.5 instrument in battling a 0

27/6 29/6 1/7 3/7 5/7 7/7 9/7 11/7 13/7 15/7 17/7 19/7 19/7 21/7 23/7 25/7 29/7 31/7

high rate of inflation. Thirdly, by intervening and keeping the move in a much wider band compared to a rupee from appreciating, the RBI encour-few years ago. ages greater inflows – there is no cost

to those who borrow abroad. These pro-

ponents currently lie low partly because of the languishing export sector after Given the above divergent views, what do the global financial turmoil and the we discern if we analyse exchange rate general scepticism surrounding any radi-movements since January 2007? The year cal policy changes in the management of 2007 saw a considerable appreciation in the external sector. the rupee, both in nominal and real terms

An exactly opposite view – consistently till about January 2008, despite persistent pressed by some economists and trade net purchases of foreign currency by the associations in general – is that RBI should RBI, buoyed by a surge in net capital intervene more

Table 3: Weighted Averages of Daily Call/Notice Rates in Per Cent Per Annum:

– – – – – – – Call Rates Repo Rates – Outside the RBI CBLO Rates

flows, particularly portfolio and external to the market till about May 2009, to some rupee-dollar rate to recover after it reached commercial borrowing (ECB) flows. The extent counteracting the dip in supply a low of Rs 51.23 in March 2009 to Rs 47.77 Rupee appreciated by about 9% against through ECB and FII flows, helped the in June 2009 (Graphs A and B, p 26).

tuations, it remained positive throughout July 29 8,000.00 61 26,942.55 19 8,000.00 0.00 99.20 3.23 76,500.00

(0) (0.00) (0) (0.00) [99.20] [3.23]

Figures in parenthesis in cols 3 to 6 represent numbers and amounts of non-competitive bids which are not included in the total. most months remained negative and Figures in square brackets under cols 8 and 9 represent weighted average price and respective yield.

turned significantly positive only during Table 6: Auctions of 182-Day Treasury Bills (Amount in rupees crore)

early 2009-10. ECB flows remained posi-Date of Notified Bids Tendered Bids Accepted Subscription Cut-off Cut-off Amount Auction Amount Devolved Price Yield Outstanding tive throughout the period, but these No Face Value No Face Value on PDs (Rupees) Rate on the Date (Amount) (Amount) (Amount) (%) of Issue

2008 after September 2008, and picked up only July 9 1,500.00 83 3,923.46 46 1,500.00 0.00 95.58 9.27 20,288.00 in June 2009 (Table 1, p 25). (1) (500.00) (1) (500.00) [95.55] [9.34]

July 23 1,500.00 83 4,232.25 23 1,500.00 0.00 95.56 9.32 19,683.00

(0) (0.00) (0) (0.00) [95.58] [9.27]

2009of foreign currency equivalent to $74.88 July 8 1,500.00 52 4,717.00 5 1,500.00 0.00 98.32 3.43 20,375.00 billion during January to December 2007, (0) (0.00) (0) (0.00) [98.32] [3.43]

July 22 1,500.00 47 3,870.00 28 1,500.00 0.00 98.30 3.47 20,375.00

(0) (0.00) (0) (0.00) [98.33] [3.41]

Figures in square brackets represent weighted average price and the respective yield. these interventions, the rupee appreciated. Figures in brackets represent numbers and amounts of non-competitive bids which are not included in the total.

The RBI continued with its net purchases Table 7: Auctions of 364-Day Treasury Bills (Amount in rupees crore)

Date of Notified Bids Tendered Bids Accepted Subscription Cut-off Cut-off Amount

Auction Amount Devolved Price Yield Outstanding

No Face Value No Face Value on PDs (Rupees) Rate on the Date (Amount) (Amount) (Amount) (%) of Issue

negative, though ECB flows remained posi-2008tive, together accounting for a total flow of

July 2 1,000.00 106 3,385.55 13 1,000.00 0.00 91.62 9.17 56,220.00

(1) (8.75) (1) (8.75) [91.78] [8.98]

July 16 2,000.00 109 4,703.50 48 2,000.00 0.00 91.39 9.45 55,886.00

(1) (250.00) (1) (250.00) [91.42] [9.41]haps contributed to the sharp depreciation July 30 2,000.00 153 9,661.00 25 2,000.00 0.00 91.30 9.56 in rupee-dollar rates from Rs 39.37 to Rs (1) (36.55) (1) (36.55) [91.31] [9.55] 55,923.00

42.13 during January-May 2008. Net sales 2009 July 1 1,000.00 56 3,650.00 8 1,000.00 0.00 96.34 3.81 46,491.00

(0) (0.00) (0) (0.00) [96.36] [3.79]

July 15 1,000.00 79 4,965.00 16 1,000.00 0.00 96.45 3.69 45,500.00 to have helped the rupee to remain stable (2) (259.42) (2) (259.42) [96.46] [3.68]

at around Rs 42.80/90 till August 2008. July 29 1,000.00 46 3,070.00 24 1,000.00 0.00 96.35 3.80 44,464.00

(0) (0.00) (0) (0.00) [96.40] [3.74]

Figures in square brackets represent weighted average price and the respective yield. ing supply through sales of foreign exchange Figures in brackets represent numbers and amounts of non-competitive bids which are not included in the total.

august 22, 2009 vol XLIV No 34

MONEY MARKET REVIEW

53

51

49

47

45

43

41

39

Graph D: Spot Quotations for the Dollar in the Domestic Inter-Bank Market

(Monthly Averages) (Jan 2001 to June 2009) (Daily) Working Days July 2009

In sum, except during early 2008 when RBI interventions seemed to have hastened the process of depreciation by and large, the interventions were counteracting market trends – purchases when market supply is large and sales when market supply dips, thus avoiding gyrations in rupee-dollar rates. Currently, there has been augmentation of supplies through both ECB and FIIs and RBI seems to have started purchasing foreign currency from the market, preventing any quick appreciation of rupee. But, when the RBI starts attempting to exit from the policy of excessive monetary accommodation, this is going to pose a dilemma and it may perforce be compelled to allow the rupee to appreciate in the near future. To what extent and at what pace this may happen will however be determined by the need for maintaining incentives for exports which are really in bad shape, and the overall liquidity conditions.

The above analysis makes it clear that, though not explicitly stated, there does not seem to be any change in the approach to exchange rate policy or management in recent months.

2 Money, Gilt-Edged and Forex Markets

The two major events affecting market expectations during the month were the presentation of the Union Budget on 6 July and announcement of the first quarter Review of Monetary Policy on 27 July. The higher fiscal deficit and the enlarged borrowing programme of the union government were causes for depressing market sentiments. There were signals domestically and from abroad that the early recovery prospects of the economy were bright, excepting the agriculture and export sectors, which were adversely affected. The return of capital flows helped boost market sentiments and the rupee became more stable after touching lows in previous

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August 22, 2009

months. The very high borrowing pro

gramme led the government to front-load

its primary issuances and the pattern of

borrowing and market preferences were

in favour of relatively short-term invest

ments, particularly treasury bills. Money

market activity, in general, remained sub

dued, perhaps because the liquid funds

found their way into the credit, bonds and

securities markets. The rates however

remained flat, but marginal pressures are

seen building up during the course of July.

government auctions, the financial system

did not face any liquidity shortage as the

volume in the repo market was much larger

in comparison to June.

number of issues in the primary market,

reflecting the front-loading strategy of the

government, bearing in mind the need for

conducting a large borrowing programme

in the remaining part of the financial year

without market disruptions and ensuring

credit flow to the commercial sector. The

forex market saw the rupee-dollar rates

touching Rs 49 and, in comparison to June,

the rupee was slightly weaker in July. The

strengthened position of the dollar vis-à-vis

other currencies and low FII investments

in the first half of the month were some of

the reasons for the rupee weakening.

2.1 Money Market

The daily average volume in call and notice money markets witnessed a sharp fall in July. The reported volume was Rs 6,313 crore vis-à-vis Rs 8,647 crore in June. However, the weighted average call rate was in the range of 3.13% to 3.27% – similar to the month of June. The mean value of the call rate was 3.08% with a standard deviation of 0.66 (Table 3, p 27). The notice money market saw nearly a 70% fall in daily average volume, July reporting Rs 1,391 crore vis-à-vis Rs 4,653 crore reported in June. The volatility in the market had increased – the standard deviation during July was 0.98 compared to 0.48 in June. The trends exhibited in the CBLO and repo markets were similar (Table 4, p 27). There was a slowdown in the beginning of the month, but a gradual pickup was seen in the later part of the month. There was a substantial fall in repo transactions outside the RBI from Rs 1,85,570

vol XLIV No 34

(-) means no trading. YTM = Yield to maturity in per centage per annum. CY = Current yield in per cent per annum. SGL = (RBI’s) Subsidiary General Ledger. OMO = Open Market Operations. OMC SB= Oil Marketing Companies Special Bonds. NDS = Negotiated Dealing System. OM = Order Matching Segment. Securities with small-size transactions (Rs 25 crore or less) have been dropped from the above list but included in the respective totals.

(1) Yields are weighted yields, weighted by the amounts of each transaction. (2) Current yield has not been worked out for treasury bills. (3) For Floating Rate Bonds (FRB’s) Current yields are based on the latest half-year yield determined in the auction.

august 22, 2009 vol XLIV No 34

Graph E: Annualised Forward Premia in Percentage for the Dollar in the dominated by 91-day bills Graph F: Yield Curves for Dated Securities – Weighted

Domestic Inter-Bank Market and Weighted Averages of Call Rates for July 2009 Averages for the Second and Last Week of July 2009

3.00 3.05 3.10 3.15 3.20 3.25 3.30 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 6 month Weighted Averages of Call Rates (Right axis) 1 month – – – – – – – – – – – – – – –

30/6 3/7 6/7 9/7 12/7 15/7 18/7 21/7 24/7

which is usual when the market expects a rising interest rate scenario.

3.1 Dated Government Securities

The 16-year high fiscal deficit confronted by the government puts pressure on it to plan its ways of raising funds ahead of the pickup in economic activity, adopting a “front loading” strategy. In the month of June and July, government issued a total volume of Rs 82,000 crore in dated securities. The maturity of 2014 and 2015 dominated issues, sharing Rs 23,000 crore out of the total issue of Rs 33,000 crore. The bid-cover ratios were more than two times for these issues. One of the auctions, for 2021 maturity witnessed a devolvement on primary dealers. During the course of the month, fresh issues were cut off at higher yields indicating increasing pressure on interest rates. For instance, the cut-off yield for 6.07% 2014 on 31 July was 6.74% compared to 6.49%, two weeks earlier.

State government borrowings amounted to Rs 12,300 crore by nine states with the state of Andhra Pradesh and Uttar Pradesh issuing bonds on two occasions. The yield from these securities ranged from 7.77% to 7.97% and recorded a bid-cover ratio of 3.3. The yield on securities issued by Andhra Pradesh was 7.93%, with a bid ratio of 2.76 at the first instance; the yield was 7.97 % and the bid ratio was 3.35 at the second instance. Uttar Pradesh state securities yielded 7.97% (highest yield) with bid-cover ratio of 2.39 at the first instance and a yield of 7.8% with a bid-cover ratio of 2.59 in the second instance.

3.2 Treasury Bills

The total issuance under treasury bills of all maturities aggregated Rs 40,000 crore in July against Rs 22,000 crore in June,

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August 22, 2009

8

crore. The preference to issue short-term securities may be due to the large issuance of government bonds and investor resistance to long-term bonds

Yield (% per annum) 5 5.5 6 6.5 7 7.5 Week ending 31 July Week ending 3 July

in the current context of interest rates bottoming out. This preference is evident from the very

27/7 30/7

high bid-cover ratio of

more than three times in all issues. The

cut-off yields picked up during the course

of the month from 3.11% to 3.23%.

Rs 3,000 crore and cut-off yield ranged

from 3.41% to 3.43% and the 364-day bills

were issued for an equivalent amount at

cut-off yields of 3.69% and 3.81%. The cut

off yields in the treasury bill auctions

showed some softening in July compared

to the previous month, thanks to the huge

demand for these short-term instruments

(Tables 5, 6 and 7, p 28).

3.3 Corporate Bonds

Corporate bonds amounting Rs 10,430

crore were issued in July. These accrued

from 28 issues. The issues from corporates

and the central undertakings dominated the

issuance market equally with respective

shares of 31% (Rs 3,530 crore) and 33%

(Rs 3,325 crore). FIs’/Banks’ share was

16.7% while that of non-bank finance com

panies (NBFCs) was 17.4%. A larger volume

of Rs 2,000 crore came from the Indian Oil

Corporation with triple A rated bonds

maturing in three years with a coupon of

7%. Rural Electrification Corp also issued

bonds worth Rs 2,000 crore. The Life Insur

ance Corporation of India issued bonds of

Rs 1,100 crore topping under NBFCs. These

bonds carried a coupon of 7.45% in three

years maturity. In the banks segment, the

participating banks issued lower and upper

tier-II bonds and perpetual bonds, with

maturities spanning 10 years and carrying

coupons from 8.54% to 9.15%. Two issues

had provisions for step-up by 50 basis

points if call was not exercised at maturity.

performed better in comparison to June

with issues of Rs 10,430 crore, which is

reflective of an improving investment

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