 "Liquidity tightening steps have led to collateral damage: Jayesh Mehta")
The Reserve Bank of India (RBI)’s recent steps to tighten liquidity might turn out to be counterproductive, as these may raise long-term rates without affecting short-term ones much, says Jayesh Mehta, managing director and country treasurer (global markets group), Bank of America. In an interview with Manojit Saha, he says the high current account deficit (CAD) in the last few years has been financed by equity inflows, which could stop if the India growth story is disturbed. Edited excerpts:
RBI has mandated foreign institutional investors secure the mandate of participatory-note holders to hedge currency on their behalf. How would this affect the exchange rate?
The fundamentals (causing the currency to depreciate) don’t change with these steps. It was perceived some market players were taking advantage of the arbitrage between offshore and onshore currency derivatives market. Even if they weren’t, it was a clarification of the previous norms for sub-accounts...So, this does not change anything; no flexibility is lost for end-users. It is more of a guidance they have given and, hopefully, this would have some impact on stemming the weakness of the rupee.
The central bank’s steps to tighten liquidity were aimed at curbing speculation in the foreign exchange market. Do you think these steps would provide stability to the exchange rate?
The idea of tightening the money market is to make the carry cost expensive. The aim is to make exporters bring money faster and discourage importers to buy forwards, as it becomes expensive. Banks had covered their positions for the previous week. So, the impact of the July 15 measures started becoming visible from last Monday—the start of a new fortnight. Again, no fundamental change would take place due to these steps. But it might have some temporary stabilising effect.
What are the risks of the liquidity-tightening measures?
The issue is these have led to a lot of collateral damage, both in the equity market, because of growth, and the bond market, particularly for long-term bonds.In 1998-2000, at the height of the Asian currency crisis, call rates had risen to 50 per cent. But there wasn’t much impact on the long-term yield. At that time, there was no government borrowing programme like the one we have now. Also, the Fiscal Responsibility and Budget Management (FRBM) Act wasn’t there. Because of FRBM, the government cannot carry out private placements with RBI. Now, while liquidity in money has been tightened, there are government bond auctions of Rs 15,000 crore and Rs 12,000 crore of treasury bills every week.
How is the situation different now?
At that time, there was no supply that the market had to absorb. In 1998-2000, all new supplies were placed directly with RBI; these didn’t burden the market. So, only the money market remained tight. The long-term yield was affected, but not in the magnitude seen now. Now, what is happening is the money market is tight and there is supply, which is affecting the long-term yield. This time, in spite of overnight rates not being that tight, the impact on long-term rates is much higher.
How long can the markets afford these curbs on liquidity?
There are two major worries. We still haven’t seen equity outflow. There has been debt outflow, but 90 per cent of that is hedged, which doesn’t have much impact on the rupee. Also, most equity investments aren’t hedged, which would have a larger impact on the currency. Till now, we haven’t seen equity outflows. We have had a large CAD (current account deficit) for three years, and funding it through equity inflows.
Now, if these measures remain for long and companies start reducing their growth forecasts and the macro growth story is disturbed, it could have a severe impact on equity flows and, therefore, the rupee. The challenge is how fast RBI can reverse these steps. The second issue is the impact on banks, as these would have huge mark-to-market (revaluation at current prices/assets) losses in the July-September quarter if these steps are not reversed well before September 30.
RBI has mandated foreign institutional investors secure the mandate of participatory-note holders to hedge currency on their behalf. How would this affect the exchange rate?
The fundamentals (causing the currency to depreciate) don’t change with these steps. It was perceived some market players were taking advantage of the arbitrage between offshore and onshore currency derivatives market. Even if they weren’t, it was a clarification of the previous norms for sub-accounts...So, this does not change anything; no flexibility is lost for end-users. It is more of a guidance they have given and, hopefully, this would have some impact on stemming the weakness of the rupee.
The central bank’s steps to tighten liquidity were aimed at curbing speculation in the foreign exchange market. Do you think these steps would provide stability to the exchange rate?
The idea of tightening the money market is to make the carry cost expensive. The aim is to make exporters bring money faster and discourage importers to buy forwards, as it becomes expensive. Banks had covered their positions for the previous week. So, the impact of the July 15 measures started becoming visible from last Monday—the start of a new fortnight. Again, no fundamental change would take place due to these steps. But it might have some temporary stabilising effect.
What are the risks of the liquidity-tightening measures?
The issue is these have led to a lot of collateral damage, both in the equity market, because of growth, and the bond market, particularly for long-term bonds.In 1998-2000, at the height of the Asian currency crisis, call rates had risen to 50 per cent. But there wasn’t much impact on the long-term yield. At that time, there was no government borrowing programme like the one we have now. Also, the Fiscal Responsibility and Budget Management (FRBM) Act wasn’t there. Because of FRBM, the government cannot carry out private placements with RBI. Now, while liquidity in money has been tightened, there are government bond auctions of Rs 15,000 crore and Rs 12,000 crore of treasury bills every week.
How is the situation different now?
At that time, there was no supply that the market had to absorb. In 1998-2000, all new supplies were placed directly with RBI; these didn’t burden the market. So, only the money market remained tight. The long-term yield was affected, but not in the magnitude seen now. Now, what is happening is the money market is tight and there is supply, which is affecting the long-term yield. This time, in spite of overnight rates not being that tight, the impact on long-term rates is much higher.
How long can the markets afford these curbs on liquidity?
There are two major worries. We still haven’t seen equity outflow. There has been debt outflow, but 90 per cent of that is hedged, which doesn’t have much impact on the rupee. Also, most equity investments aren’t hedged, which would have a larger impact on the currency. Till now, we haven’t seen equity outflows. We have had a large CAD (current account deficit) for three years, and funding it through equity inflows.
Now, if these measures remain for long and companies start reducing their growth forecasts and the macro growth story is disturbed, it could have a severe impact on equity flows and, therefore, the rupee. The challenge is how fast RBI can reverse these steps. The second issue is the impact on banks, as these would have huge mark-to-market (revaluation at current prices/assets) losses in the July-September quarter if these steps are not reversed well before September 30.