RBI choses growth over inflation, what does it mean for the rupee?

Momentum in the rupee has again kept markets in dilemma after RBI’s recent policy. The RBI has used its latest monetary policy review to explicitly indicate that it will prioritise the revival of economic growth over inflation. The RBI stated that it would “continue with the accommodative stance as long as necessary to revive growth on a durable basis and mitigate the impact of COVID-19 on the economy”.

In our previous report, we had mentioned that RBI might have to conduct more OT’s in order to bring down the rising yields and reduce borrowing costs for government and corporates to boost spending.

Currently, RBI may have to confront two challenges that are as follows:

• Falling growth and Rising Inflation: Generally whenever growth comes down, inflation comes down but this time the growth has fallen by nearly 24 percent in the first quarter of the year and Inflation is consistently above 6 percent since December. If the government steps in with a package of spending to incentivize our economy, then the RBI could struggle to keep inflation capped. When Inflation is moving higher; technically RBI will reduce the pace of buying dollars, as when RBI buys dollars, they give rupee liquidity into the system. From the last 10 to 15 trading sessions, we have seen RBI supporting the rupee at 73.00 to 73.20 levels, but we are not sure that with rising inflation, how long they can keep buying.

• Containing rising 10 Year Bond Yield with OT’s: India’s bond market, responded well to RBI’s move. The 10-year yield dropped from 6.02 on Friday to 5.89 today, reducing the cost of capital a bit. In order to finance the fiscal deficit Gap, both center and state have to constantly borrow, which will eventually increase the 10-year yield. Rising yield will increase the borrowing cost across the entire spectrum from government to corporate, which will adversely impact the flow of credit.

Ideally in the current scenario, RBI shall continue to do “operation twist” means selling shorter-term maturity bonds and buying long-term maturity bonds. RBI had said it would double its open-market bond purchases and would contain yields on the longer tenure using “operation twist.” When RBI does operation twist and if it continues to buy dollars, it pumps rupee liquidity into the system it could further add inflationary pressure and nullify RBI’s motive of flattening the yield curve.

As the focus was on a growth recovery, this was evident in RBI’s plan for liquidity infusion of another Rs 1 trillion via Targeted long-term repo operations (TLTRO), which would let banks cheaply borrow longer-term funds from it against top-rated securities. In addition, it said it would buy bonds issued by states and made home loans even more affordable. The TLTRO package aims to provide money in the hands of lenders for lending to specific sectors. With commercial activity picking up and consumer confidence picking up, RBI is seeing both supply and demand in sync.

Interestingly, the MPC subtly tilted away from its inflation-targeting mandate by deemphasizing the risks on the prices when it gauged that supply disruptions were mainly responsible for keeping inflation above the tolerance band for months. It presumed that these disruptions should fade as the economy unlocks, activity normalises and supply chains are restored.

Outlook:

Amid rising inflation, renewed need for OMO’s and OT’s, RBI might get less active and aggressive in buying dollars and might have to get more tolerant to rupee appreciation. Hence, any major inflow could drive the pair towards the stronger end 72.50-72.70 levels. Overall, it is expected that the pair shall continue to trade sideways within the range of 72.50-74.50 levels for the near to medium term. Until it breaks 74.50 levels, every uptick shall remain selling opportunity.

Strategy

Strategy for Exporters:

Thin Margin: For new orders, thin margin exporters shall not get complacent and begin selling in tranches on upticks close to or above 73.45-73.50 levels. For open orders, it is advisable to maintain a stop-loss of 73.20 or cost whichever is higher. Overall, we suggest following a 70-80 percent hedge ratio.

Thick Margin: For fresh exposures, it is suggested to sell close to 73.50 levels. For the ones holding, are suggested to maintain a stop-loss of 73.00 and follow a hedge ratio of 50-60 percent.

Strategy for Importers: It is advisable to cover payments within the next 15 days to 1 month on dips between 73.00-73.15 levels. To hedge more than a month, one can opt for at the money call option to keep the downside open.

-Amit Pabari is managing director of CR Forex Advisors. The views expressed are personal.