How Russian Dollar Sell-Off Will Impact RBI’s Balance Sheet And Interest Rates

US Treasury data, released last week revealed that in April, Russians halved their holdings of US Treasury assets. In one month alone, the Russian central bank sold a little more than $47 billion of US Treasury security. In January 2014, Russian holdings of US treasuries amounted to $132 billion. The 2014 reference period is used since the stock of securities was prior to the referendum in Crimea that integrated the region into the Russian mainland.

Since the beginning of the US sanctions, Russia has consistently reduced its dollar dependence and shifting to gold as a reserve as opposed to the US dollar. India, however, continued its purchases and has accumulated US Treasury assets worth $153 billion. That is from between January 2014 and April 2018 Indian US Treasury security holdings rose 125 per cent. That mean 37 per cent of India’s foreign currency reserves are held in U S treasuries. Russian central bank though held a bare 10 per cent of its reserves in US treasuries.

The large dollar treasury holdings have exposed the Reserve Bank of India’s (RBI) balance sheet to external foreign fluctuations. The US Federal Reserve since last year has consistently raised its key interest rate, the federal funds rate (a rate at which US banks and financial institutions borrow or lend from each other), signaling exit from the money expansion since 2008. An increase in the Fed funds rates means a tightening of dollar liquidity or flight of funds from around the world. In effect, it would translate, depreciation of dollar investments for the RBI on a marked to market basis.

Marked to market essentially implies a realisable value in the event of asset liquidation in the short or near term. RBI by convention marks to market its foreign currency assets on the basis of the last working day of each month. In June 2017, the yield of the US Treasury 10 year security was 2. 3 per cent. This montth (June 2018), the value has dipped to 3 per cent, meaning a depreciation of 0.7 per cent in the value. According to the US Treasury Department, about 85 per cent of Indian holdings are in long term assets.

In the global sell-off however, India has not been an outlier. In fact, the RBI has been an aggressive trader. This time though unlike Russian or Chinese central banks, the liquidation of dollar assets were on far less scales. The RBI’s sell-off during March and April were just about $5 billion, though it is unlikely to have incurred any substantial trading profits. That is because, most of the sales have occurred at a point when interest rates were on the ascent. When interest rates rise, usually, the value of bonds depreciates in value. As a result, the yields of the bonds rise to correct for the hardening interest rates.

However, dips in the value of foreign currency assets means the ability of the RBI to transfer greater resources to the government by way of surpluses getting adversely impacted. Last year (2016-17), the RBI transferred Rs 31,000 crore as dividend to the government. This was about 60 per cent of the dividend transfers from the entire financial sector – public sector banks and insurance companies. Budget 2018-19 has scaled down dividend expectations from the financial sector.

Clearly, the message is that surplus transfers from the RBI this year are unlikely to be substantially higher than the previous year, the single reason being shortfalls in earnings from foreign currency assets. Trading in these securities or assets comprise a substantial portion of the RBI’s income. Last year for instance, the earnings including trading income from foreign currency assets were down 35 per cent over 2016 or over Rs 100 billion (Rs 10,000 crore). Given the movement of US interest rates, foreign investment trading income has taken a hit. The full impact of dollar interest volatility would be known when the RBI releases its annual report in August this year for the financial year 2017-18.

But the dip in income from foreign sources and the impact of the rapid sell-off by foreign central banks in turn would most likely affect the domestic liquidity environment. This is because dollar inflows have been a major contributor to domestic liquidity. The domestic liquidity occurs through RBI purchase of foreign currency and pumping in rupee liquidity into the banking system. Indian Ratings and Research, a subsidiary of global credit ratings company, Fitch ratings, cautioned, “domestic financing market could be impacted by rising externalities, elevated global yields and pressure on the Indian currency; II) impact on input costs; III) abrupt outflow of funds from the country; and IV) volatility in the currency markets.” Hikes in US interest rates obviously lead to flight of investment capital, turbulence in the currency markets, with consequent impact on input prices (read energy prices ). All these events have already begun to pan out.

It is clearly these concerns that came out in the RBI Governor Urjit Patel’s Financial Times article on 5 June this year. Patel’s article admitted as much: “emerging markets have witnessed a sharp reversal of foreign capital flows over the past six weeks, often exceeding $5 billion a week”. Dollar outflows mean a tightening of domestic liquidity, which is precisely what has been happening.

Costs of borrowing have been on ascent, as reflected by the 0.25 per cent increase in the repurchase rate of the RBI. The repurchase rate, or the repo rate as it is commonly referred to, is the RBI’s overnight financing window to domestic banks against a collateral of government securities. That rate was hiked to 6.25 per cent. A hike in this policy rate in turn means that deposit and lending rates across all sectors could rise in the coming weeks.

A rise in interest rates may not be bad. For deposit rates any increase may actually be good. A rise could perhaps reverse the flight of household savings to non-financial sectors, particularly gold. After all it is household savings that have been the single largest component of capital funds for investment, whether in the public sector or in the private sector. On the flipside, interest rates need not necessarily rise, if the pace of asset recoveries in the banking sector continues.