The Liquidity Crisis: Foreign Banks Play and the Nation Pays

As a matter of fact, most of the foreign banks globally and in India, too, employ kin of policy makers and government officials with generous compensation

September 05, 2013 8:13 IST | India Infoline News Service

In the last six weeks, RBI has resorted to unprecedented liquidity tightening to curb speculation in the currency market. One pertinent question is: who are these speculators misusing local liquidity to manipulate the currency? Primarily, five foreign banks. No Indian bank or domestic company can engage in such speculation. Here is how it works. When foreign banks sense that the rupee is fragile, they buy forward dollars and sell the rupee in the non-delivery forward (NDF) overseas markets on their proprietary books. Typically, sellers of dollars in NDF market are Indian corporates with overseas subsidiaries, NRIs, Indian-origin diamond traders, etc, who then try to hedge by buying dollars in local market. As the rupee weakens, many exporters extend their credit periods and importers contract them. Foreign banks then use local liquidity to further go long on dollars on the pretext of hedging their custody assets. Typically, they use overnight indexed swaps to pass on the interest rate risk to PSU banks and get their borrowing costs fixed. 

Many of these foreign banks use their public relations network and research reports from their own houses to influence policy makers’ thinking to not intervene in the currency market. As a matter of fact, most of the foreign banks globally and in India, too, employ kin of policy makers and government officials with generous compensation. China is investigating such employments. Their reports will say “RBI reserves cover imports for only seven months, market is supreme, one should not intervene, etc”. The fact is that RBI reserves cover more than 18-24 months’ trade gap (excess of imports over exports) as we are not shutting down our exports tomorrow. Also, regulators world over do intervene to ensure healthy functioning of the markets. The same foreign banks have different prescription in their own home countries suggesting intervention with easy money and credit to overcome the crisis. 

Actually, no speculator can match RBI’s reserves and strength. If RBI can manage a surprise swift operation in currency by selling say $20 billion, it can wipe out all the speculators. All traders and speculators essentially work with stop-loss whereas RBI has no such restrictions. One may argue whether it is appropriate for RBI to do so, but consider the cost of not doing so. When RBI intervenes with paltry $100 million, traders at desks of foreign banks, have a good laugh. 

Who pays the price? The entire nation. Given the multiplier impact of cut in money supply, the banking system seems to have run out of money. It impacts lakhs of enterprises and crores of people. Banks have been refusing to disburse even the sanctioned loan and not allowing withdrawal from cash credits/overdraft limits. The abrupt disruption in the flow of liquidity causes heart attack-like situation for many otherwise healthy businesses. Imagine if all deposit holders of the banks were not to renew their deposits or ask for their money back overnight. No bank would survive such a scenario. Many enterprises are not able to pay their creditors in time and many others have been forced to abruptly halt their projects. Banks are also facing risks of increased NPAs and losses. While they will defer booking of losses on G-Secs by treating them as HTM (hold-to-maturity), confidence of individuals and mutual fund G-Sec investors is irreparably shattered. 

It will not be fair to blame the RBI or the government for the current situation. Under the circumstances, the decision to tighten liquidity was taken with good intention. With hindsight, we know it has not only failed to deliver the desired results, but has also caused a huge collateral damage. To fix a problem created by a few miscreants, the action seems to be crippling the entire system. We have seen rare simultaneous spooking of equity, debt and currency (rupee) markets, all witnessing much sharper fall after the tightening. This has aggravated the outlook for the economy as well as Indian corporates, scaring foreign investors of equity as well as debt. The RBI should be quick to reverse these decisions. We should listen to our own senior bankers, for example, the chairman of our largest public sector bank who advised “hike the rate but don’t choke liquidity” or the ex-chairman of the largest private bank who warned against using outdated text-book approach. The Indian economy has fundamental strength and ability to attract foreign capital. The crisis is one of confidence and sentiment. The new RBI governor can take some courageous steps to restore confidence of Indian business, on which global investors bet. 

The above column appeared in the Economic Times dated September 05, 2013

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