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RBI should provide a band for Re movement

Pranav Thakur

BOTH the forex and the bond markets witnessed much volatility in the last fortnight. The rupee came under pressure on the back of some genuine importer and FII buying, which saw it hit a low of 44.70 against the dollar.

If the Reserve Bank of India had wished, it could have stalled the fall of the rupee at any point by just opening a window at a particular level. But it chose not to, either because it actually wanted the rupee to depreciate gradually as in REER terms th e unit is overvalued, or, it did not want to expend its reserves. I think it is the former that led to only a half-hearted intervention from the central bank.

But once the rupee crossed 44.50, the RBI seemed to get uncomfortable. And the moment it touched 44.70, the central bank came out with measures (thankfully non-monetary) to protect it -- the most important being a 50 per cent surcharge on import finance and a minimum 25 per cent rate of interest on overdue export bills. Though the rupee quickly appreciated to 44.10 levels soon after the announcements, it has continued to fall since, albeit slowly, and has again touched 44.65 in spite of t he RBI's continued dollar sales through some nationalised banks.

This brings us to an issue that has been spoken about on various occasions -- that of providing the rupee a corridor for movement rather than pegging it to a particular level. At times of strength, the RBI should let the rupee appreciate a li ttle before coming in to mop up dollars. Also, instead of sticking to a small two-three paise band, it should try and buy at various levels. This would lead to two-way movement in the currency.

As of now, any level that the rupee settles down at becomes the floor price, which works to its disadvantage during volatility. As the market has only seen the rupee depreciate in the past, any level becomes one to buy. So once the rupee starts to move, importers see no benefit in waiting and exporters see none in selling (at least for some time), and the whole thing snowballs into a crisis. Such big, one-way movements in the currency could be checked if it were allowed to float in a 1-1.5 per cent band .

This would also help sentiment in the bond market, where traders are still nursing their wounds from the January 1998 crisis -- volatility in the currency market just shakes their bones. Any rupee volatility, thus, causes a big sell-off in the bond market. And that is what happened this time around as well. In paise terms, the long-end has dropped about twice as much as the currency. In fact, we joke that our market operates to a mathematical equation where the sum of the currency and half the bond price is a constant. Every currency fall is matched by a commensurate fall in bond prices.

The yield curve has not only moved up but has also steepened, thanks to a Rs. 5,000-crore 11-year auction. Announced in the middle of the currency crisis, the auction only added to woes at the long-end, where sentiment has been bearish even in better tim es. This auction pushed up the yield curve at the long-end quite sharply without the RBI actually collecting anything. Ninety-eight per cent of the issue devolved on the central bank, which it is now trying to sell through its OMO.

Sentiment with regards to liquidity in June continues to be bearish. The RBI will have to mix private placements with auctions to tide over the month. Given that the currency is under pressure, the central bank's job becomes all the more difficult. RBI, however, will have to put on hold its long-end issuances for the time-being, or like the last time round, will end up steepening the yield curve without pushing any of the Government's borrowing to the market. People who were holding on to the long-end i n the last two months have lost a great deal of money and it will take time for sentiment to improve.

If the RBI does refrain from issuing long-term paper, this should be a temporary top for the long-end. Sentiment in the overseas markets has also improved in the last week, which should trickle down into our markets as well. The dollar inflows owing to F II purchases last week should help the rupee to some extent. If the currency stays stable, it is a good time to buy govvys maturing between 2007-11. Thin tenor spreads between one and five years makes the medium-end unattractive.

(The author is Trader, Interest Rates, HSBC. The views expressed here are his own and not necessarily those of his employer.)