## Tuesday, February 19, 2008

### RBI does forwards

I wrote an article in Business Standard today, pointing out that RBI has started doing currency transactions on the forward market on a pretty large scale, and that this isn't such a good idea.

1. Why do you assume that the RBI transactions on the forward market are purchases? The RBI could be buying on the spot market and selling on the futures market to avoid monetary expansion and to hedge against exchange rate losses.

Also, if there are reasons to believe that pressures on rupee appreciations are temporary, as was the case toward the end of last year because of increasing global risk aversion, then it makes sense for the RBI to hedge by engaging in longer maturity transactions. i.e. buy spot rupees and sell forward dollars 6-12 months down the line. This would reduce immediate pressure on the rupee to appreciate due to spot-future arbitrage and also reduce the short term volatility of the currency, which is one of RBI’s goals. And, cetris paribus, lower exchange rate volatility is better.

Shouldn’t the RBI not only should the RBI trade the rupee derivative market, it should also trade offshore rupee market?

2. I agree with you: the transparency is poor, and one doesn't know. We're only being shown the outstanding position (and some maturity buckets) on a monthly basis. Intra-month trades and positions are not known. That's what I alluded to in the article, where I say that one reason for RBI to favour the forwards is the shroud of non-transparency.

Using forward positions to hedge against losses on the core reserves position?? No, that would just not work - the reserves are too massive! There's no way the market would absorb even a $20 billion open interest of an RBI forward position. I agree with you that the reserves is a large risk management problem, but the way to address that is to reduce reserves. Pressures on rupee apprecation being temporary: then how do you get sustained unidirectional purchase of USD from circa 2001 onwards? In your second paragraph there is an assertion about volatility. I am not able to see how that is true. Once you start trading the onshore forwards, the logical next step is to trade the offshore forwards as well. My suggestion would be: Don't do any of this. Central banks are about monetary policy, not running a hedge fund. 3. Many central banks are already acting like hedge fund. The PBoC, BoJ and the Saudi Arabian Monetary Authority are known to have invested in more than just government bonds. The PBoC, for example, is known to have invested in asset backed securities. And I wouldn’t be surprised if central banks have tried to increase return by actively managing the duration of their treasury portfolio. Moreover, central banks with large forex reserves (RBI, PBoC, BoJ, SAMA etc) have diversified their assets. So one can assume RBI has considerable expertise and knowledge in global currency. Its investments in onshore and offshore rupee derivatives are just an extension of that. Don't you think the RBI has a fiduciary duty towards the Indian taxpayers to maximize return for a given level of risk? So what is wrong in RBI uses forwards to hedge a part of its reserves. 4. > Moreover, central banks with > large forex reserves (RBI, PBoC, > BoJ, SAMA etc) have diversified > their assets. So one can assume > RBI has considerable expertise > and knowledge in global currency. Hmm, last I looked, I didn't see hedge funds recruiting out of RBI. > Don't you think the RBI has a > fiduciary duty towards the > Indian taxpayers to maximize > return for a given level of > risk? The job of a central bank is to create the fiction of fiat money that makes the market economy possible, and to do so in a way that stabilises the business cycle. The game is about setting and varying the interest rate at zero maturity so as to help to stabilise the business cycle. No other goal should be allowed to creep in, at the expense of this core function. > So what is wrong in RBI uses > forwards to hedge a part of its > reserves. I do not think you should use the word "hedging" to describe what RBI has been doing on the forward market. 5. Very Interesting article. However, have you looked into the fact that forwards have gone into a discount. Interest rates in India are still quite high and the forwards should be at a premium ( more so if RBI has a huge long), however they can be at a discount of there are huge shorts which could be those of RBI Please note: Comments are moderated. Only civilised conversation is permitted on this blog. Criticism is perfectly okay; uncivilised language is not. We delete any comment which is spam, has personal attacks against anyone, or uses foul language. We delete any comment which does not contribute to the intellectual discussion about the blog article in question. LaTeX mathematics works. This means that if you want to say$10 you have to say \\$10.