Bank of America (NYSE:BAC) (BofA) analysts noted a shift in the trading behavior and volatility of the Indian Rupee (INR), attributing the change to a recent alteration in the Reserve Bank of India (NS:BOI)'s (RBI) approach to managing the currency.
The analysts indicated that the RBI has moved from using foreign exchange reserves to shield domestic monetary conditions to utilizing interest rates to defend the INR while conserving reserves.
This change in strategy comes after the INR experienced pressure in the fourth quarter due to a correction of over-valuation relative to its peers. The transition in RBI leadership has acted as a catalyst for this shift. BofA's analysis suggests that the use of interest rates to defend a currency is generally less effective in the short term, which could lead to increased volatility for the INR.
The report also observed that the market has adjusted its expectations for the RBI's policy-rate outlook, moving away from anticipating easing at the February policy meeting. The transmission of FX volatility to domestic rates has raised the risk of the RBI maintaining tighter financial conditions than might be justified by domestic factors alone.
The analysts noted that the RBI's liquidity injections, whether through FX swaps or repo operations, have not been sufficient to address the tighter liquidity in the call money market. This indicates a preference by the RBI to raise the cost of shorting the INR and to clear the forward book.
BofA concluded that while the short-term effects of these changes might lead to elevated front-end swaps, the increased FX flexibility could be seen as a positive development in the long term. It could create room for more relaxed monetary conditions at a later stage, once the RBI's non-deliverable forward (NDF) book is cleaned up.
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