RBI does forwards

Business Standard, 20 February 2008

RBI has embarked on doing currency trading through the forward market. This may at first appear to be a good idea, because the forward premium is smaller than the cost of MSS. In this article, I argue that there are deeper difficulties with this strategy. The international best practice involves central banks not trading on currency derivatives markets.

As with all financial derivatives, the spot market and the derivatives market are tightly bound by arbitrage. From the viewpoint of a market manipulator, manipulating the spot is tantamount to manipulating the derivative, and vice versa. In order to understand the situation correctly, it helps to take a "one market" perspective, with a unified view of all positions on all kinds of traded products off a given underlying.

Until September 2007, RBI's position on the currency forward market was 0. The table, drawn from the February 2008 edition of the `RBI bulletin', shows that a forward position has sprung up, going from zero to $5 billion in October to $8.2 billion in December.

Oct '07Nov '07Dec '07
Purchase on spot market12.57.82.7
Forward position5.07.68.2

Simple addition of the currency purchase of a month and the forward position of the month is, of course, wrong. How does one put together the flow of purchases versus the stock of positions? A simple thought experiment is: Suppose the forward position were forced back to 0. This would require a purchase of $8.2 billion on the spot market to hold the exchange rate constant. Hence, the apparent spot market intervention data for the 3 months (12.5+7.8+2.7 or $23 billion) is understated by $8.2 billion. The intervention of these three months was truly $31.2 billion. Instead of a monthly average of $7.7 billion, it's truly a monthly average of $10.4 billion a month. This works out to roughly 5% of reserve money a month, or an essentially unsustainable pace of reserves accumulation.

RBI does certain disclosures to the IMF SDDS program which are not noticed by most people in India. This data, on the RBI website, shows the maturity structure of the forward position on 31 Dec 2007. As of this date, the long position of $8.238 billion falls into three buckets: $0.8 billion of less than a month; $1.8 billion of 1-3 months and the bulk of it or $5.7 billion between 3 and 12 months. These are some pretty long maturities.

At first blush, this makes simple business sense. The cost of MSS issuance is roughly 7.5%. The implicit interest cost in forward prices is lower. So it saves money to do intervention through the forward market. A deeper look shows four good reasons for avoiding trading on the forward market:

  1. Central banks normally exercise parsimony in their interventions. That is, they limit their intervention only to the short end of the bond market and the currency market, leaving the private sector to determine long rates by themselves. That way the central bank can have some influence on the markets while still allowing price discovery to take place in the bulk of the maturity spectra. This system allows the central bank to obtain helpful information, particularly on the credibility of its policies. For example, if it pushes the short rate down and longer rates fail to fall, this is a signal that the markets don't believe the policy is sustainable. If the central bank trades at longer maturities, this flow back of information into monetary policy formulation breaks down. Specifically, in the Indian case, deviations from covered interest parity show the currency expectations of the private sector. By trading on the forward market, RBI loses this information.
  2. Forward interventions are now published, but there is less transparency (given existing disclosures) with RBI purchases of forwards as compared with RBI purchase on the spot (which is simple and clean). Doing trades on the forward market is also attractive as a way to bypass limits on MSS. Indeed, Korea intervened forward precisely because it had exhausted the National Assembly's bond limits and didn't want to publically ask for an increase.
    When RBI purchases on the spot, the interest cost of MSS is borne by MOF, but when RBI purchases the forward, the forward premium is borne by the RBI. There has to be a strong reason to trade the forward, and I believe this lies in avoiding transparency and evading the MSS limits.
  3. When a central bank buys dollars forward it is taking a speculative position -- it can lose money if the spot rate subsequently appreciates. Such a loss would be very different from valuation losses on reserves, for it is a cash loss, which must go through the P+L account. Most central banks are terrified of this possibility, especially as there have been some well known cases of central banks incurring huge losses from such speculation. Korea's speculation lost the country billions a few years back, leading to National Assembly hearings.
  4. Precisely because central banks are worried about such outcomes, speculative positions distort exchange rate policy. Once the central bank has placed a bet on the movement of the exchange rate, it will not want to let the rate go the other way. So policy becomes subordinated to the need to avoid losses (eg, Philippines in the 1980s and 1990s). A large forward position becomes an incentive to reduce exchange rate flexibility, to force the spot exchange rate to go to places that makes the authors of the forward position look smart. Or sometimes the speculative bets are increased to counter the market pressure, ultimately resulting in huge losses. This is what happened in Thailand and Korea. The initial bets were small, but since the exchange market pressure refused to subside, the central banks' positions just grew and grew, ultimately resulting in enormous losses.

In the delicate language of economists, RBI has an `inconsistent' monetary policy framework. The present structure of currency and interest rate policies are internally inconsistent. The private sector knows that this monetary policy regime will break down, which induces massive speculative pressures upon the regime. A sound monetary policy framework is one which is consistent, and thereby speculation-proof. A wise central bank would confront the inner contradictions, instead of looking for clever adventures. Such adventurism complicates the situation, and increases the cost of exiting from the present monetary policy regime.

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