Bank of America (BofA) analysts noted a shift in the trading behavior and volatility of the Indian Rupee (INR), due to the recent change in the Reserve. Bank of India (NS :)'s (RBI) for managing the money.
The analysts pointed out that the RBI has moved from using foreign reserves to protect domestic financial conditions to using interest rates to protect the INR while retaining reserves.
This change in strategy comes after the INR gained weight in the fourth quarter due to overvaluation correction relative to its peers. The shift in the leadership of RBI has been the catalyst for this trend. BofA's analysis suggests that using interest rates to hedge currencies is generally less effective in the short term, which could lead to more volatility for the INR.
The report also noted that the market has changed its expectations for the RBI's policy rate outlook, moving away from expecting a easing at the policy meeting in February. The spread of FX volatility to domestic rates has increased the risk that the RBI will maintain tighter financial conditions than may be justified by domestic factors alone.
Analysts noted that the RBI's liquidity injection, whether through FX swaps or repo operations, has not been sufficient to address the tighter liquidity in the call money market. This indicates that the RBI would prefer to raise the cost of shortening the INR and clear the forward book.
BofA concluded that while the short-term effects of these changes could lead to high-risk swaps, the increased FX flexibility could be seen as a positive long-term development. It could create room for more relaxed monetary conditions later, once the RBI's non-deliverable forward (NDF) book is cleared.
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