April 3, 2017 / 5:15 AM / 5 months ago

Indian markets bet on a hands-off RBI and stronger rupee

FILE PHOTO: People walk past the Reserve Bank of India (RBI) head office in Mumbai, India, November 9, 2016.Danish Siddiqui/File photo

MUMBAI/NEW DELHI (Reuters) - The Reserve Bank of India's mysterious tolerance of a stronger rupee has completely upended market expectations, with traders who once braced for record lows becoming their most exuberantly bullish since Narendra Modi was elected Prime Minister in May 2014.

Bullish bets are piling up, with the Reserve Bank of India surprising investors with only feeble attempts to curb a rupee rally.

Those modest measures have sparked a range of speculative theories, including a view that the RBI's reticence is intended to keep India from appearing on U.S. President Donald Trump's currency manipulator radar.

Regardless of the RBI's intentions, traders appear emboldened to aggressively short dollar/rupee in spot markets, even as the rupee has hit its strongest against the dollar since October 2015 at 64.7650, to become the best performer among Asian peers.

But a continued rupee rally carries economic risks, given it could threaten a nascent recovery in exports, which account for nearly a fifth of India's economic output at a time when domestic demand remains weak.

"A large number of speculative USD/INR shorts have built up on expectation that intervention will not be very heavy," said Sajal Gupta, head of forex and rates at Edelweiss Securities.

"People are trying to test new higher rupee levels."

Based on positioning in markets, traders are looking at 64.80 as the next support level which was breached on Monday and then 63.50, the 200-day moving average and the strongest since July 2015.

The shorts are profitable for traders given they can deploy rupees in short-term investments such as commercial paper that yields more than 6 percent.

GUESSING RBI'S INTENTIONS

Still, allowing such a sharp rise marks a surprising turnaround for the typically interventionist RBI, which had until mid-March defended the 66.10 level for nearly a year.

It also marks a shift from just a few months ago when some analysts were warning of a record low in the currency. A Reuters poll in March showed bullish bets on the rupee rose to their highest since May 2014, when Modi was overwhelmingly elected in the midst of a market rally.An official aware of RBI's forex policy said its reluctance to intervene was consistent with its policy of intervening only during excessive market volatility, while noting intervention would be ineffective in light of a surge in foreign investments.

The rupee's ascent has been fuelled by a net $8.85 billion in foreign investments into debt and equities in March - the highest monthly amount since at least 2002 - after Modi's party won key state elections this month.

The official said the RBI believed the economy was robust enough to withstand a stronger currency.

"These are huge genuine flows driven by India's strong domestic fundamentals," said the official.

"RBI doesn't have any (rupee) level in mind while deciding its fx stance. One needs to look at what's happening to other emerging market currencies as well."

The RBI's muted stance contrasts with previous Governor Raghuram Rajan's approach in which the RBI aggressively capped the rupee by buying dollars to build foreign exchange reserves.

Still, traders speculate the RBI is, in fact, hamstrung in intervening.

Some traders, for example, point to the about 4 trillion rupees ($61.63 billion) in cash held by lenders after Modi unexpectedly banned high-value banknotes, leading to a surge in deposits of the proscribed bills.

The RBI may be reluctant to add those large deposits by buying dollars and selling rupees, given the inflationary impact it could have at a time when the central bank has changed its monetary policy stance to "neutral" from "accommodative."

The government itself is keen to pin the rising rupee to India's sturdier economy at a time when New Delhi wants deflect any criticism of its controversial cash move.

"There is no need to panic," said a senior government official who deals with currency issues.

"The recent rupee appreciation will not have much impact on India's exports."

But the RBI policy of tacitly allowing the rupee to rise carries risks if government officials and the RBI are over-confident about the economic outlook.

The stronger rupee could instead hurt exports just as they showing signs of strengthening, with overseas shipments in February at their highest since December 2014.

Measured by the real effective exchange rate, the weighted average value of a currency versus other major currencies and adjusted for inflation, the rupee is now 11 percent overvalued.

Another official who advises the government acknowledged the risks of a strong currency, but said the rupee would reverse course.

"Over the next year, we could expect the rupee to remain in the range of 66-68 assuming there are no big shocks in the global economy," he said.

"India can't afford any significant appreciation of the rupee."

($1 = 64.9050 Indian rupees)

Reporting by Suvashree Choudhury and Manoj Kumar; Editing by Rafael Nam and Eric Meijer

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