In recent times, there has been some debate around the extent of External Commercial Borrowings (ECBs) raised by Indian borrowers that are ‘unhedged’, i.e., where the borrower has left the currency risk open.
Beyond just ECBs, the larger question is whether there is any pent-up complacency or vulnerability in the overall market positioning that could give rise to one-sided currency flows depending on the unfolding news and sentiment.
One way to gauge the direction and possible extent of such positioning would be to compare RBI’s net intervention in the currency markets with the net durable flows into the market. We find that a significant accretion to RBI’s currency buffers over the last three years was funded by less durable flows, suggesting some vulnerability in market positioning.
Flows during FY20 to FY22
Consider the three-year period spanning fiscal years 2019-20 (FY20) and 2021-22 (FY22).
During this period, across its spot and forward currency market intervention, the RBI net purchased a record USD 210 bn. As a result, the total foreign exchange buffers of the RBI (across on-balance sheet foreign exchange reserves and off-balance sheet forward purchases of foreign currency) rose to a healthy USD 672 bn as of end FY22.
While this significant accretion to currency buffers offered (and continues to offer) several degrees of policy freedom to India, consider how much of this accretion was funded by durable flows, and how much by reversible flows.
Let us start with durable flows. During this period, India’s net Current Account Deficit (CAD) stood at USD 40 bn. On the other side, we saw net Foreign Direct Investment (FDI) inflows of USD 126 bn. In addition, over the years, we have seen a steady rise in the level of Non-Resident Indian INR repatriable (NRE) deposits. If we were to (arguably) consider net flows into NRE deposits also as durable inflows, that amounted to another USD 18 bn of inflows during the period. Together, the net durable flows across CAD, FDI, and NRE deposits during FY20-FY22 stood at USD 104 bn.
Of the total USD 210 bn of net purchases by RBI, therefore, USD 104 bn can be attributed to durable flows. The balance USD 106 bn likely represents less durable and more reversible flows.
Of these less-durable flows, USD 16 bn were net Foreign Portfolio Investment (FPI) flows across equity and debt markets. Despite some significant net inflows during the last two months, about USD 8 bn has moved out in FY23 so far. The rest likely arose from ECB and other debt inflows, from net exporter hedging, and from other speculative currency positions.
Should foreign debt inflows accrete to RBI buffers?
At the core, if foreign currency debt raised by domestic borrowers makes its way into RBI’s net foreign currency buffers, that represents an increase in open currency exposures somewhere in the ecosystem. After all, the debt needs to be repaid; if the borrower had hedged her future liabilities by buying foreign currency in the forward market (supplied say by an exporter), there would be nothing left to be absorbed by the RBI net across spot and forward markets.
What if the ECB were designated in INR? RBI’s financial stability report of June 2022 tells us that nearly USD 17 bn equivalent of ECBs denominated in INR were outstanding as of March 2022. In such cases, rather than the borrower, the overseas lender runs a currency risk on INR. If the flows from this such ECB were to make their way into RBI’s buffers, they still represent an open INR risk taken on by an international lender. This lender could turn up to buy foreign currency against INR if sentiment were to turn.
What if the borrower herself were an exporter, and therefore had a natural hedge for her ECB payables with future exports? Shouldn’t that leave her with foreign exchange to be supplied to the market today, which could make its way into RBI’s buffers? In such cases, any accretion to RBI buffers would simply represent bringing forward of future export receivables, or in other words, net exporter hedging.
In a country with a history of regular current account deficits, all net exporter hedging resulting in an accretion to RBI’s currency buffers leaves open the vulnerability of a larger net demand for foreign currency in the future.
It is of course true that as the size of India’s economy grows, a higher level of outstanding ECBs can be sustained. Nevertheless, debt flows that make their way into RBI buffers represent a potential future demand for foreign currency, especially under conditions of stress.
While India has enjoyed a healthy rise in foreign exchange buffers between FY20 and FY22, a chunk of this accretion likely arose from less durable sources such as portfolio flows, ECBs and other external debt, net exporter hedging, and other speculative positions.
Since then, between April and July 2022, the RBI sold an estimated over USD 45 bn across spot and forward currency markets to control USDINR movements. About half of this is accounted by the net durable outflows across CAD and FDI. The remaining half likely funded a reversal of some of the open positions that had been built up over time.
This is not to suggest that there is any immediate issue on the INR front. RBI’s foreign exchange buffers are still substantial. Commodity prices have come down in recent weeks, offering welcome relief. RBI has shown considerable commitment to managing currency movements, across market intervention, verbal intervention, and policy steps. Any initiation of INR settlement of our trade with Russia can significantly reduce our hard currency outflows.
Nevertheless, the build-up in reversible flows over the past few years suggests a possible vulnerability in our currency market positioning, which merits monitoring. As we have seen in recent times, any weakening of sentiment could spark nervous demand for foreign currency from these accumulated positions.