The Reserve Bank of India (RBI) is being forced to forsake the rupee at record lows not merely by a shortage of ammunition to defend the currency but also by a compulsion to relieve stresses in the local debt market.

RBI

RBI

The RBI's hands-off approach is a factor that has pushed its tumbling currency to new lows each week. Its options are limited. Only about 6 percent of its $314 billion reserves are freely usable to intervene in currency markets. Even if it intervenes, that dollar-selling could take rupees out of an already tight and stretched banking system.

Yet intervene it must, else a plunging currency will not only push the near-double-digit inflation even higher but also set off a negative spiral of capital outflows that will end in a severe balance-of-payments crisis.

Trading at a record low of 53.64 per dollar, the rupee is close to the 55-level that market participants regard as a line in the sand. That is the level at which a creeping sense of anxiety over the balance of payments could give way to panic and distress.

Analysts suspect the RBI is buying time. It can conserve FX reserves by waiting, and then step in with a combination of rupee-buying intervention and repos or other open market operations (OMOs) to replace the rupees it is soaking up.

The RBI's capability of intervening in the FX market has been severely hampered by the tight liquidity conditions in the money market, said Abheek Barua, chief economist at HDFC Bank. This is now proving to be a problem with the rupee hitting record lows. To ease the liquidity cash crunch, it may start boosting the size of its OMOs as it will give it some much-needed headroom to intervene on the rupee.

That is where intervention policy gets tricky. The RBI has been providing increasing amounts of cash to its banking system. But it is doing so in phases to put a lid on surging bond yields and smooth a massive government borrowing.

With annual inflation still running at above 9 percent and barely weeks after it raised rates for a 13th time, the central bank has to be careful how much cash it pumps in.

The question is, does the RBI want to signal that it's prepared to ease? said Suresh Kumar Ramanathan, head of strategy at CIMB in Kuala Lumpur. I do agree that intervention which is sterlised does not do any good in limiting this rupee weakness, he said. The RBI ought to be signalling a willingness to ease policy if it complemented its rupee defence with open market operations, he said.

BEHIND THE CURVE

The rupee has dropped 19 percent against the dollar since July, as much as it did during the worst of the Lehman crisis. The RBI's presence in the market has been sporadic and fleeting, giving analysts the impression it is prepared to risk being behind the curve.

A few indicators in the rupee market are screaming crisis. For instance, the cost of swapping rupees into dollars in one-year offshore forwards has hit 7 percent, inching closer to the one-year rupee bond yield at 8.15 percent.

The big fear is that when the rupee hits the 55 level, it will trigger massive hedging by oil firms and importers and by holders of the huge amounts of dollar debt falling due in early 2012. That could push the rupee to 60 and beyond within days.

I think 55 is a good level for the RBI to intervene, said J. Moses Harding, head of asset-liabilities committee at IndusInd Bank. It would also encourage exporters to book their receivables and not trigger a widespread panic among importers.

Technically, the RBI could spend a big chunk of its $314 billion in reserves defending the rupee. Practically though, it has to set aside cash for at least 8 months of import payments, possible portfolio outflows and short term debt, leaving it with just around $20 billion of spare cash.

A member of the prime minister's advisory team, M Govinda Rao, admitted the central bank's intervention capacity is limited, yet he urged the RBI to step into the markets.

Since the 2008 financial crisis, inflows other than stable foreign direct investment -- namely, short term dollar borrowings by companies and flows into equity and bond markets -- have propped up India's growing trade deficit.

Of capital inflows totaling $120 billion over the past three years, nearly two-thirds has come from such sources, Morgan Stanley strategists say.

That difference could be crucial if the euro zone crisis explodes into a Lehman-like scenario.

Morgan Stanley expects the rupee to weaken to 54.8 by the second quarter of 2012 while UBS's short-term dollar/rupee target is 55.

The RBI is content with suppressing bond yields and managing expectations in the money markets.

Ten-year bond yields have fallen nearly 50 basis points in the last two weeks, down from a more-than three year high of over nine percent. One-year overnight-indexed swaps are pricing in nearly 100 bps of cuts over the next year.

That may help the rupee in the medium term by taking some of the pressure off banks in supporting the government's bloated borrowing plan.

As the rupee threatens to break out above 55 per dollar, it could spark inflationary expectations which would end up pushing bond yields higher, unless the RBI conducts more aggressive liquidity injecting open market operations, said Ashok Bhundia, a rates strategist at Bank of America Merrill Lynch.

HELPING THE BOND MARKETS

Admittedly, while some of the central bank's reserves may be fickle hot money, it still could sell dollars from its reserves while adding funds to the bond market by resorting to bigger buybacks.

Another option would be for it to quickly replace its reserves and the rupees in the banking system with dollar-rupee swaps.

It could also resort to cuts in reserve ratios and privately buying bonds from the government

At a debt quota auction for foreigners at the start of this month, investors scrambled to get a chance to buy bonds and paid record commissions.

For the first time in three years, net foreign purchases of government debt have surpassed their equity investments. Year-to-date, they have bought more than $6 billion in bonds compared to a paltry $46 million in equities.

This is largely due to the RBI restarting its bond buyback operations after nearly a year. Rajeev Malik, a senior economist at CLSA in Singapore said the central bank may sound a dovish note and announce bigger buybacks when it reviews policy on Friday, and follow up possibly with a cash reserve ratio cut next month.

While it may also give the RBI some headroom to intervene on the rupee, if necessary, its decision would be keeping in mind at the growing cash shortage in the market, Malik said.

He expects ten year yields to fall further to 8-8.20 percent in the coming days.