RBI intends to use FX reserves to control bond index inflows

The persons, who wished to remain anonymous due to the confidential nature of the negotiations, said that the Reserve Bank of India intends to use its almost record-high $642 billion in reserves to both absorb the inflows and balance the outflows.

FX reserves are India's primary instrument for controlling inflows into bond indexes.

According to those familiar with the central bank's thinking, India's enormous foreign currency reserves would act as the first line of defense against any market volatility resulting from an anticipated spike in inflows once the nation's bonds are included in international indexes.

The persons, who wished to remain anonymous due to the confidential nature of the negotiations, said that the Reserve Bank of India intends to use its almost record-high $642 billion in reserves to both absorb the inflows and balance the outflows. The RBI is not now concerned about the direct effects of the bond inclusions, but if substantial flows continue, the central bank may decide to modify its liquidity framework in the future to include foreign currency intervention as an official weapon, according to the sources. Any change will be a divergence from the present strategy, which calls for FX intervention to reduce volatility.

According to the sources, the central bank would urge the government to issue market stabilization bonds in addition to using its existing instruments, such as a standing deposit facility, to control domestic liquidity. According to the sources, some of the measures are only being discussed and may not even be put into action.

In June, JPMorgan Chase & Co. will add India to its index of developing countries bonds. The business estimates that this move might bring in up to $25 billion for the debt market in India. India is anticipated to be included in Bloomberg Index Services Ltd.'s developing markets index starting in January. Bloomberg Index Services is a division of Bloomberg LP, which manages indexes that are in competition with those of other providers.

By the end of June of next year, the central bank anticipates that at least one more index provider would follow suit, according to the individuals. India is already being considered for inclusion in the developing market bond index of FTSE Russell.

According to the persons, India anticipates that the inclusion of the bonds would probably lead to an improvement in its sovereign credit rating and increased foreign investments into the nation. At present, Fitch Ratings Ltd. and Moody's Ratings have India rated at the lowest investment grade.

The rupee, which has been among the least volatile emerging market currencies internationally, will face challenges from the inflows to the RBI's firm hold on the currency. Building foreign currency reserves is essential, as Governor Shaktikanta Das has made clear, in order to protect against market selloffs.

Usually, the central bank purchases surplus dollars when foreign inflows increase, keeping the local currency from depreciating excessively and mitigating market volatility. When the rupee is under pressure, reserves are depleted by selling dollars and purchasing local currency on the open market.

According to estimates from Barclays Plc, reserves have increased more each month during Das's leadership than they have under any previous Indian central bank governor. During times of dollar strength, as the majority of 2022, when reserves fell $100 billion in about nine months, Das hasn't been afraid to use reserves.

Stability of Currency

According to sources acquainted with the RBI's thinking, the institution is committed to preserving the value of the local currency both in the face of increasing inflows and in the case of outflows due to abrupt reversals. The people argued that the central bank still favors market determination of the local currency rate, despite its alleged strong hand. Officials said that while they are aware that the rupee may rise, they will not allow it to deviate too far from its peers.

Thus far this year, the Indian rupee has outperformed all other developing Asian currencies. The currency is down 0.4% while the Korean won and Indonesian rupiah have declined by 3-4%.

However, the RBI's involvement in the foreign currency market has come under scrutiny. In December, the International Monetary Fund referred to the RBI's actions as "excessive," meaning that the bank was attempting to manipulate the value of the rupee. India has furthermore been listed by the US Treasury as a possible currency manipulator on its blacklist.

Das has continuously defended India's intervention strategy, claiming that it serves as "an insurance against spillover risks" resulting from the actions of industrialized nations' central banks.

An email requesting further details was not immediately answered by the RBI.

Tools for Liquidity

Any change in exchange rates might also have an impact on the liquidity of the local rupee and monetary policy, which is intended to control inflation.

According to one of the sources, the central bank's favored tool for removing the excess liquidity building is probably the standing deposit facility, which was initially implemented in 2022, and will be used to counter such flows.

Banks may deposit cash with the central bank during the SDF window, a liquidity absorption window, and get interest that is 25 basis points less than the policy rate set by the RBI. The RBI no longer has to hold additional bonds since it is not required to provide any security in exchange for this cash. According to the people, the central bank's variable rate reverse repo or repo operations can handle a comparatively lower liquidity flood or shortfall.

According to the sources, the central bank is also considering launching more sophisticated derivative products to provide investors with suitable interest-rate hedging instruments. Additionally, they said that it anticipates a surge in activity in the current standard hedging instruments, such interest rate futures.