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RBI Calms Markets By Downplaying Inflation, Talks Up The Rupee

In a sudden move today, the 10 year bond yield came down from the 9.1% it started with down to 8.91%. At the same time the rupee rose abruptly from the Rs. 63.75 to a dollar in the early part of the day to close at Rs. 63.31. (That part could have been because the RBI was selling dollars, and I suspect that to be the case)

The reason: Dr. Raghuram Rajan decided to calm markets by talking about how the “fundamentals” don’t support a rupee drop. Let’s take a look.

There is no Forex Problem

RBI Believes the current account deficit will be substantially lower this year.

I am especially happy about the 13.5% increase in dollar exports since last October, the reduction in imports by 14.5% and dramatic reduction in the trade deficit by 48%. Our estimate is that the Current Account Deficit (CAD) for this year will be about $ 56 billion, less than 3% of GDP and $ 32 billion less than last year.

Of course, some of that compression comes from our strong measures to curb gold imports. One worry is whether gold is being smuggled in sizeable amounts, and is being paid for through the havala channel. While we do see a sizeable increase in seizures, we believe gold smuggling has increased from a low base, and is still small.

This is excellent news, but we’ll know the extent of the truth only when the BoP data comes out later this quarter. The problem with Gold isn’t immediate – obviously even smugglers take time to regroup. It’s that they are much more difficult to control after they’ve got their act together.

FIIs can Go, We’ll Be Okay

Here’s the math:

Last year FII inflows, both debt and equity, accounted for 26 billion dollars. Let me assume that we get no inflows this year, and in fact outflows equal the inflows we got last year. In other words, there is a 52 billion dollar turnaround in FII flows. Remember though that we have $32 billion dollars less of CAD to finance this year, and till yesterday, we raised $ 18 billion of money through new channels. So if other financing remains the same as last year, which it seems on track for, even if foreign investors pull out significantly more money this year than they have so far, we still can break even on capital flows.

But let me ask this. Why did the rupee depreciate so much in August? The CAD came down because of the rupee drop. Despite the rupee drop, we are still in deep deficit mode. The deficit is the problem – because it has to be financed through a rupee depreciation in the absence of fund inflows. The RBI has no enthusiasm to sell a lot of dollars.

Yes, we have some dollars come in on the FCNR swap but that money is not hitting the markets, and any volume that doesn’t hit the markets, is not present to offset any of the dollar buying that is currently *in* the market. RBI is trying a little to sell what it can, but it’s really not doing that much.

Therefore the fear that the rupee will depreciate is real. Even if we were to reduce $32bn off the CAD – and we won’t because the gold smugglers would have figured things out by then – we will have a problem if fund flows reverse. Most of the trading is based on sentiment, and everyone knows there is a lot more than $26 billion out there for the withdrawing, especially if there is a US taper.

So while this is interesting math, it doesn’t quite work out if you change the assumptions on the drop of the CAD, the fact that RBI can’t get itself to sell dollars in quantity, and that FIIs may pull out a lot more than they did.

Oil Companies are Buying Dollars from the Market!

Rajan says:

As the exchange market stabilised, we allowed oil marketing companies to return and purchase more and more oil from the markets, starting on October 14. Today, a month later, I am glad to report that the majority of oil marketing company demand for dollars is back on market. The market absorbed the additional demand quite smoothly – in fact, participants did not even know it was back until some talk from the Finance Ministry last week.

Reading this carefully, it is now evident that the RBI has only managed to build reserves because oil companies could buy directly from the market. (Otherwise, whatever it earned through the FCNR swap – $18 billion – would go out to the OMCs) It is also evident that while oil companies bought some dollars from the markets in October, the bulk of such buying is likely to have been in November. Because he says that “Today” the majority of oil marketing demand of dollars is back on the market – meaning, it wasn’t so earlier in October.

When did the rupee start to reverse? Uhem, let’s see.


So if it was November that OMCs bought a lot from the market, and it was November that the rupee depreciated from Rs. 61 to Rs. 63, then how can we say it isn’t fundamentals that’s driving the rupee down?

Meanwhile, understanding this, the RBI has decided to keep the swap open and *finally* revealed when the swaps will unwind- Feb-Apr 2014.

The OMCs have entered a swap arrangement whereby they will have to repay dollars to the RBI on various dates from February 2014 till April 2014.

Rajan has said the swaps could be rolled over further if OMCs can’t buy from the market to pay back. This is a threat – “if forex markets don’t behave, we’ll fund these guys indefinitely through our reserves.”. But it is an empty one, because RBI as we’ve noted, cannot get itself to sell dollars that easily.

Inflation is Not a Problem, We are not Hiking Rates Yet

While CPI came in at 10.1%, Rajan looked instead at “Core” CPI:

Turning to inflation, the new CPI index came in at 10.1%. Food inflation is still worryingly high, and the effects of the harvest are still awaited. But looking through the headline numbers, I am somewhat more heartened by the outcome of core CPI inflation, which declined to 8.1 percent from 8.5 percent in September. The momentum for core inflation is also on the decline.

I don’t agree with this because I simply don’t agree on looking at “core” numbers ignoring food when, for most of the economy, food is “core”.

But they’re adamant they won’t do it.

We will watch the incoming data carefully, especially looking for the effects of the harvest on food prices as well as the second round effects of fuel price increases and exchange rate depreciation, before we make further decisions on interest rates.

There’s an OMO, so they Sold Dollars?

They say:

While borrowing from the MSF facility has come down substantially after the RBI extended the term repo window, market interest rates suggest some liquidity tightness. To alleviate this tightness, we propose to conduct OMOs. On next Monday (November 18), we will undertake an OMO for Rs. 8,000 crore

Wait one little tiny second. There is NO problem of liquidity in the market. MSF borrowing has dropped to less than 20,000 cr. People are borrowing in term repo because it’s cheap money! There is no real issue with respect to liquidity, so what could it be?

I believe the RBI has been selling dollars. If they sold $1.5 billion over the last few days, they woudl have taken Rs. 8000 to 9000 cr. out of the liquidity in the markets. To build that back, they will do an OMO – where they purchase bonds from banks and give them rupees.< /p>


The first impact will be positive. For banks. For the rupee, and even for bond yields. But this is a great vantage point to help enter into short side trades. Because no matter what they’ll have you believe, you know that fundamentally the rupee continues to be weak, and is perceived as such.

The OMO will perk up bonds and set up lower yields. Short term bond funds which were losing money might turn positive again. Longer term bond funds would already have gained.

Bank Stocks have some embedded weakness, and might only recover for a short time.

Disclosure: Have positions in Bank Nifty options.

  • Leo says:

    the problem is here DEEPAK …it is a minsky moment for the world..they stay in denial about the borrowings which are not creating growth coz it is driving capital into stocks.Second No one wants to believe that real estate will collapse which reduces the savings.And then there is indirect tax of inflation.
    Once the UST not 10 year goes past 3% everyone is going to blink .Our guys will just have a heart attack coz rates on gsec can really scare on the upside.there is a view that YELLEN will increase bond purchases.Which can happen as the central bankers are insane crowd and she is the queen of insanity.
    which will put pressure on INR again. 9% + is a breakout zone for a bull mkt in YIELDS.
    I was shocked to listen to threatening calls of FM and Mayaram
    “I think a crazy, irrational kind of a sentiment is (prevailing in the forex market)… Whoever is punting on rupee will lose very heavily. I feel very sorry for their families,” Dr. Mayaram told reporters here.
    Meanwhile, Finance Minister P. Chidambaram held a meeting with foreign institutional investors (FIIs), who were ‘bullish’ on India.
    After the meeting, Mr. Chidambaram said, “everyone was here, everyone was bullish, there were no concerns.” The meeting took stock of the current economic situation.—————————————
    IT SHOWS WHAT IS GOING ON IN STOCK MKT ….he wants to pump it up at any cost.
    So IT MEANS RUPEE soon will hit 90 to a dollor or more and these guys are in panic .It is s the same feeling when someone is naked short and the mkt moves against him.

  • px says:

    The quantum of intervention , coupled with the problem of growing twin deficits and hidden inflation make for an eventual one sided bet !
    When the money was flowing in the sentiment was akin to a steroidal high
    Now when the money flow reverses , charsis will get withdrawal symptoms!
    Whatever Rajan does, he cant just talk the currency mkts in the direction of his liking , just like Chidu cant talk up the financial markets any more…
    Taper or no taper, all the conventional ammo with the fed is fast loosing its firepower !

  • DJ says:

    “I am somewhat more heartened by the outcome of core CPI inflation, which declined to 8.1 percent from 8.5 percent in September”
    Did he really say that?! I can’t believe that any central banker anywhere can say that he is heartened by a statistically insignificant decline in inflation when it is at such a high level.
    This can only mean one thing. That the alternative: rise in bond yields at the long end is a far more worrisome prospect. Rajan is in a Catch-22… we need inflation to come down, but can’t increase rates as banks will fail. So, we have to sit and pray that inflation comes down on its own. Everybody pray real hard (but don’t buy gold to offer in temples.. lol).

  • Getafix says:

    There you go.
    James Bond AKA Rajan turns out to be just another “respected economist” a la MMS, Chiddu and Ahluwalia, trying to use his past reputation to talk up the markets.
    Frankly I didn’t think it was going to be any different.
    Why would they let a dissenter take the post at all.

  • Kaka says:

    I have a question. Rajan focused on the CAD and money flows in making the case for a strong rupee. But, aren’t CAD and flows merely secondary issues. Aren’t there primary reasons like low productivity, low competitiveness, bad infra, no manufacturing policy, bad tax and legal policies, high inflation, etc which are the primary cause for poor investment prospects and thereby, a weaker rupee. I mean, how can he downplay inflation AND argue for a strong rupee in the same breath? Isn’t it paradoxical? And, did he really miss the point that the exports/imports rebalanced because of a weak rupee, not on their own….
    Ok, the above question might be convoluted. So, how about this:
    Shouldn’t an inflation differential of 10% imply 10% depreciation every year just to maintain status quo (with any deviation being due to real productivity growth which is close to 0 anyway if GDP is deflated by CPI)? And, if so, aren’t CAD and flows irrelevant?

  • Shankar Raman says:

    The elephant in the room that has been missed out is the $ repayment by companies that had borrowed through ECB/fccb in the pre-crisis period -as per the TRBI, this was some $140 odd billion payable between June 12 and 13. Where does this figure in the math that Raghu has put out?