That the Reserve Bank of India (RBI) is the biggest player in the domestic inter-bank Fx market is well known — during 2022-23, its gross sales were $213 billion, up 120% from the previous year. Over that period, the rupee fell by 8.3%, from 75.75 to 83, driven, to a large extent by global dollar strength during the first part of the year. Remarkably, despite the huge dollar sales, RBI’s reserves rose by about $30 bn during the financial year.
This was because as the dollar gave up most of its gains globally, the rupee began to strengthen and the RBI, clearly — and despite its stated policy of not targeting any specific exchange rate — wanted to prevent rupee appreciation beyond a point. Now, since the dollar ended the year broadly where it was at the start, there was a marginal impact of revaluation of the non-dollar reserves, which indicates that RBI’s gross purchases in the market were a huge $243 billion (about 213 plus 30), for total market activity of more than $450 billion (about $1.8 billion a day on an average).
The Bank for International Settlements conducts a detailed survey in April every three years, where it collects data on Fx transactions from central banks. In April 2022, the Indian Fx market had a daily volume of about $120 bn (about 1.6% of the total global market of $7.5 trillion); of this volume, spot, outright forwards and swaps comprised $38.5 bn, $59.6 bn and $18.8 bn, respectively; of these, interbank spot, outright forwards and swaps were $15.2 bn, $23.0 bn and $11.8 bn, respectively, for a total interbank volume of about $50 bn (not counting options). If we distil it further to simply spot and swaps, the daily interbank volume was $27 bn.
More power, then, to the RBI that it was able to control the rupee so well over the past five or six months where it has successfully blocked the rupee between 81 and 83.
One of the fallouts of this intense RBI activity is that implied volatility (extracted from option pricing) has fallen sharply over the past six months — clearly, market participants see no upside in taking on bada dada. [Historically, in FX markets, SBI used to be called daddy, but it has been long eclipsed both by agile private and foreign banks in terms of FX market volumes and, of course, RBI.] Implied vols are currently more than 1% below historic volatility (which is extracted from actual price movements of USD/INR) and have been for nearly five months, one of the longest periods in recent years.
The subdued volatility has likely been supporting portfolio inflows, since low volatility makes the carry trade more attractive. And, indeed, FII flows have been positive every day during May (and the last few days in April) — we haven’t seen such an unbroken run of positive inflows since at least 2019.
Over and above the low rupee volatility, it also appears that global investors are increasingly seeing India as one of the better investment destinations. And, with the multiple global traumas — the Russian invasion of Ukraine, will/won’t the Fed be able to bring inflation down to its 2% target —appearing to settle into an acceptable rhythm, the risk on sentiment could sustain and there could well be more inflows to come, which would result in greater upward pressure on the rupee and on RBI’s dollar buying activity.
On the flip side, it does appear that the Fed may be on track to raise rates again this month while RBI is more likely than not to stand pat. This narrowing of the interest differential will certainly feed into the premiums but may also engender a little nervousness on the spot. Again, the government’s increased defensiveness as a result of the women wrestlers’ protests, coming on the heels of its loss in the Karnataka election, may keep rupee bulls quiet for some time longer.
The important point to note is that markets don’t like to remain quiet for too long — thus, the longer this narrow jockeying continues, the more likely it is that the rupee will break out, one way or another. The low vols suggest it could be a good time to buy options.