Beating street estimates by a wide margin, the RBI’s special swap windows raised a cumulative $136.3bn by end-August, with the highest contribution (~92%) by FCNR(B) deposits at $126bn, while rest were via offshore borrowing facilities. These flows are likely to push up the foreign reserves stock to a fresh high past $750bn in the coming weeks, providing considerable firepower to defend the currency. This is already noticeable in the recent shift in the intervention bias. USDINR, which was earlier stubbornly steady in the face of strong FCNR inflows, has corrected sharply in recent sessions, testing below 95.0 handle to mid-94.0 due to strong intervention dollar sales and broader dollar swings.
Liquidity is another key watch factor. Given the swap arrangement, these inflows will add to an already abundant INR liquidity backdrop, which was at a four year high this month, depressing overnight rates. While organic drivers like tax-related outflows, and seasonal currency leakage, in addition to CAD (~1.1% of GDP), portfolio outflows, and maturity of the forwards book will act as counter-balancing factors, yet concerted steps will be required to drain the potential surge in liquidity. Near-term options include a) temporary CRR hike. While this will have an immediate impact, such a move could be viewed as effectively unwinding the RBI's earlier decision to exclude these deposits from CRR and SLR requirements. Plus, the asymmetrical availability of FCNR related liquidity might put smaller/mid-sized institutions at a disadvantage. To get around this, the ratio might be in proportion to increase in NDTL to ensure it syncs with scale of funds raised amongst banks; b) open market operations (OMOs) or market stabilisation scheme (MSS), which will mop up liquidity without distorting the FX forward curve, but could push up yields; c) sell-buy swaps, but this will disrupt FX markets and come at a high cost; d) cash management bills to bridge temporary cash flow mismatch; e) calendar for money market operations like VRRR but for shorter tenors as longer-duration (~15days) did not garner sufficient interest; f) introduction of an hybrid instrument, although given the scale, secondary impact on the bond or FX market is likely; g) raising the cost of funds through hikes, but will not address the ongoing mismatch; h) boost asset side of the book and lower dependence on bulk/ wholesale deposits. Part of the excess reserves could also offset the sizeable outstanding short forward book (jumped to record $137bn in July).
When the dust settles, focus will also be on the bunched-up maturities that will fall due in 3Y and 5Y tenor of the deposits. A portion of the existing reserve stock could be earmarked against these liabilities, helping to mitigate concerns that deposit maturities or debt repayments could trigger a sharp increase in dollar demand and exert pressure on the FX market down the line. In the near-term, priorities will be to manage liquidity, gradually lower the sizeable forwards book, and support the domestic currency. Long-end yields continue to be influenced by the hardening global yields.
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