RBI must enter forex mkt to support Re,curb inflation: BoA-ML.

Mumbai: Leading US brokerage Bank of America-Merrill Lynch (BofA-ML) has called upon the Reserve Bank to enter the forex market and buy dollars to recoup the rupee and thus arrest the imported inflation, which is the main reason for the continued price spiral.

Stating that lending rate cuts and higher forex reserves hold keys to the market and growth recovery, a BoA-ML India report authored by its chief economist Indranil Sen Gupta said, "The rupee will remain volatile till RBI recoups the forex reserves of USD 65 billion, including the forwards which it had sold since the 2008 global credit crisis following the fall of Lehman Brothers."

On imported inflation, it said a 10 percent fall in the rupee translates itself into a 100 bps rise in inflation.

Stating that non-intervention is the reason for the rupee fall, it noted that RBI is not buying forex to comfort the market because it thinks that market may sell the rupee due to a forex shortage which will further fuel inflationary pressures.

The report notes that "in September-November 2011, the steep 13.4 percent of the rupee depreciation was, after all, aggravated by payment of bunched up dues of about USD 5 billion to Iran for oil imports. A 10 percent depreciation of the currency typically translates into 100 bps of inflation."

The rupee is the second worst performer among the BRICs currencies, after the Brazilian real, losing nearly 19 percent since September 2011, the report said.

Last Friday, the rupee hit a two-month low of 55.15 to the dollar. The life-time low of the local unit was in mid-June when it had plunged to 57.15 to the greenback. In the year-to November 2, the RBI had sold over USD 21 billion to prop-up the rupee. Between August and December 2011, the rupee had lost 17 percent.

"We do not expect the forex market to get bullish on the rupee until the RBI has recouped forex reserves. After all, the country's import cover has halved to just about seven months -- the least since 1996 -- from 14 months in 2008.

"The RBI will need to buy USD 90 billion if it is to replenish the import cover to even nine months. Just as importantly, the forex market will also fear that the rupee may see disproportionate losses in case the dollar shoots up," Sengupta said.

He further said to stabilise the rupee, "The best solution surely will be for RBI to accumulate forex and the forex market to buy the rupee.

"The RBI should then achieve its twin objectives of stabilising the forex market and reducing 'imported' inflation pressures. The forex market could easily make 5-10 percent and its gains would be relatively better protected if RBI is in a stronger position to protect the rupee from contagion," the report said.

The report said "not only has RBI not been able to buy forex, but it has also actually had to sell USD14 billion forwards.

"Barring occasional bouts of optimism, most of which have ended in grief, the forex market has sold the rupee for the large part since end-2011. If this continues, the local unit would become a story of lower tops and deeper bottoms," it warned.

Stating that higher forex reserves can drive the rupee again in the 1990s fashion it said, "With the import cover down to seven months, last witnessed in 1996, RBI will again have to generate investor confidence by recouping forex reserves."

In the 1990s, the RBI used to build forex reserves as insurance cover to protect the balance of payments from a 1991-type crisis. The then governor Bimal Jalan and deputy governor Y V Reddy used to buy as much forex as possible during capital inflows and sell as little as they could during capital outflows.

They also floated the 5-year Resurgent India Bonds in 1998 after the Asian crisis and India Millennium Deposits in 2001 to raise USD 5 billion each, after the dotcom bust.

As these measures built up forex reserves, improved investor confidence led to capital inflows and by extension, appreciation. In fact the rising forex reserves drove the rupee during the FY98-2004 period.

Noting that RBI's exchange rate policy shifted gears by the mid-2000s, the report said surplus capital inflows began to push up the rupee. As a result, the RBI had to buy forex during the up-cycle of 2004-07 to stop undue appreciation the report noted.

However, it notes that the situation changed dramatically after the Lehman crisis. Capital outflows began to pull down the rupee. In response, RBI had to sell dollars to prevent a run on the rupee in 2008 and end-2011.

But it also notes that RBI attempts propping up the rupee between the second half of of 2009 and first half of 2011 against imported inflation at the cost of buying forex, pulled down the import cover down to 1990s levels.

Source : zeenews.india.com