Why RBI must permit PDS, mutual funds, insurers, others to directly access forex market

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While global growth is clearly back, most other countries have also shown strong exports, the rupee’s recent sharp surge may end up aborting this positive development. What and why is the situation as of now?

• Equally concerning is the fact that several competing currencies, including the yuan and even the Euro, have weakened against the rupee, making competition in the domestic market much fiercer, threatening the already limp Make-in-India initiative. Perhaps evidencing this, imports in March grew by a massive 47% y-o-y.
• Meanwhile, RBI is finding its hands tied on intervention because of the extraordinary overhang of rupee liquidity courtesy demonetisation. While the government may see this as simply collateral damage to its gambit for the UP election, its recent political successes result in backing FX policymaking into a corner.
• Several prominent global investors have pronounced India one of two or three prime investment destinations, the GST jubilation is yet to come, and the global investment environment is still benign, despite several known and unknowns.
• There is already a small pool of institutional investors who are getting attracted to masala bonds, which provide 7-8% (or more) dollar returns for carrying USD/INR risk. For a pension fund with tens of billions in assets, the risk/return for, say, $100 or $200 million—which is a serious amount for Indian companies—may appear quite favorable. While there have thus far been a small number of such transactions, there is little doubt that this window will widen in years to come.
• We may all have to start getting used to a stronger rupee. Unless, of course—and there’s always and unless or many—Marine Le Pen continues the populist/nationalist trend that seems to be driving the world and becomes president of France and follows through on her promise to leave the Euro.
• The only thing the central bank can do, to my mind, is to permit different entities—PDs, mutual funds, insurance companies, etc—to directly access the FX market. Globally, over 50% of market liquidity comes from such non-bank financial institutions; in India, the share is zero.
• Allowing different entities with different types of balance-sheets into the market may be the only way to generate demand for dollars from time to time to at least partly offset the strong capital flows that are boxing RBI into a corner.