India sees forex reserves as main tool to manage bond index inflows

By Anup Roy

India’s vast foreign exchange reserves will be the first line of defense against any market volatility arising from an expected surge in inflows once the country’s bonds are included in global indexes, according to people familiar with the central bank’s thinking. 

The Reserve Bank of India plans to absorb the inflows and match the outflows using its near-record high $642 billion reserves, the people said, asking not to be identified as the discussions are private. While the direct impact of the bond inclusions isn’t cause for immediate concern for the RBI, the central bank may consider tweaking its liquidity framework in future to include foreign exchange intervention as an official tool if large flows become persistent, the people said. Any tweak will be a departure from current policy where forex intervention is to smoothen volatility.

To manage the domestic liquidity, the central bank will use its available tools, like a standing deposit facility, and may also consider other measures such as asking the government to issue market stabilization bonds, the people said. Some of the measures are in the early stages of discussion and may not even be implemented, the people said. 

JPMorgan Chase & Co. will include India in its emerging markets bond index in June, with the company estimating it may draw as much as $25 billion of inflows into the country’s debt market. Bloomberg Index Services Ltd. is expected to add India to its emerging markets index from January. Bloomberg LP is the parent company of Bloomberg Index Services, which administers indexes that compete with indexes from other providers.

The central bank expects at least one more index provider to follow suit by the end of June next year, the people said. FTSE Russell has already put India on its watchlist for inclusion in its emerging market bond index.

India expects its sovereign credit rating will likely be upgraded as a result of the bond inclusions, resulting in more foreign inflows into the country, the people said. Moody’s Ratings and Fitch Ratings Ltd. currently have India on its lowest investment grade level.

The inflows would challenge the RBI’s strong grip on the rupee, which has been one of the least volatile of emerging market currencies globally. Governor Shaktikanta Das has been vocal about the need to build foreign exchange reserves as a buffer against market selloffs. 

The central bank typically intervenes in the foreign exchange market to smooth out volatility, buying up excess dollars when foreign inflows rise, thereby preventing the local currency from appreciating too much. Reserves are drawn down by selling dollars and buying local currency in the market to support the rupee when it comes under pressure.

Barclays Plc estimates that the monthly increase in reserves under Das has been higher than during any other Indian central bank chief’s term. Das hasn’t been averse to using reserves during periods of dollar strength, such as most of 2022, when reserves dropped $100 billion in about nine months.

Currency Stability
 

The RBI is determined to maintain the stability of the local currency in the face of rising inflows and in the event of outflows from any sudden reversals, people familiar with the RBI’s thinking said. Despite its perceived heavy hand, the central bank still wants the domestic exchange rate to be market determined, the people said. While officials are cognizant that the rupee will strengthen, they won’t let it move too much out of sync with its peers, they said.

The Indian rupee is the best performer in emerging Asia so far this year. The currency is down 0.4% compared with declines of 3-4% in the Indonesian rupiah and Korean won.

The RBI’s intervention in the foreign exchange market has come under the spotlight, though. The International Monetary Fund in December called the RBI’s action ‘excessive,’ implying it was trying to influence the level of the currency. The US Treasury has also previously cited India on its watchlist of potential currency manipulators. 

Das has consistently defended India’s intervention policy, saying it acts as “an insurance against spillover risks” stemming from the central bank policies in advanced economies.

The RBI didn’t immediately respond to an email seeking further information.

Liquidity Tools
 

Any currency intervention could also pose a problem for domestic rupee liquidity and will have implications for monetary policy that is aimed at reining in inflation.

To neutralize those flows, the central bank is likely to use the standing deposit facility introduced first in 2022 as its preferred instrument to mop up the excess liquidity buildup, one of the people said.  

The SDF is a liquidity absorption window where banks can park cash with the central bank and earn interest that’s 25 basis points below the RBI’s policy rate. The RBI doesn’t have to post any collateral against this cash, thus freeing up the need for it to keep more bonds. A relatively smaller liquidity surge or deficit can be addressed via the variable rate reverse repo or repo operations of the central bank, the people said. 

To give investors appropriate interest-rate hedging tools, the central bank is also deliberating introducing more complex derivative products, the people said. It also expects a spike in volume in the existing plain vanilla hedging tools, such as interest rate futures, they said.