Central banks act as dams that prevent a flood from ruining markets. But many a time, these very floodgates have to be opened to prevent damage to the structure itself.
A look at the Reserve Bank of India’s (RBI’s) forex operations tells us it is trying to defer this opening for as long as it can. RBI is stuck with a banking system inundated with copious rupee liquidity, a direct flood caused by demonetisation. What is making this worse is the unprecedented dollars that are flowing into Indian debt markets, making the liquidity problem even more vexing than before. Foreign investors have poured more than $18 billion into bonds and $9 billion into stocks since January this year and the resultant appreciation of the rupee has been over 4%.
Committed to keeping forex markets away from undue volatility, the central bank cannot ignore the dollar flow and let the rupee surge. But for every dollar it buys, it injects rupees into banks. It should be no surprise that RBI is postponing this infusion as much as it can into the future.
Enter the forward contract market wherein a forward is essentially a promise to honour a forex purchase or sale at a future date. Forward dollar purchases by RBI have gathered steam since demonetization and it has bought close to $16 billion worth of greenbacks using forward contracts in the six months following demonetization, taking the outstanding net position to the highest in three years.
That is because the surplus rupee liquidity is still close to Rs3 trillion. Had the $16 billion been in the spot market, it would have infused not less than a trillion rupees into the system, complicating the central bank’s liquidity management operations.
Further, RBI for the first time has its net forward contract stock entirely in the maturity basket of 3-12 months. Six months back, the proportion of forward contracts within this tenure was about 72% and 81% in June last year. While the central bank defers the liquidity infusion from forex operations, it is mopping up the existing surplus by selling government bonds in the market. RBI is hoping that when these forward contracts come up for maturity, the surplus would have considerably reduced.