The INR/USD rate is now nudging Rs.50 to the dollar. This is a big move over a short period: a depreciation of 12.1 per cent over the 84 days from 1 July till 23 September.
What fluctuations of the INR/USD can we reasonably expect?
After the rupee became a float, so far, it has had average volatility of roughly 9 per cent annualised. Roughly speaking, this means that over a one year horizon, the movement over a year would range between -18 per cent and +18 percent, with a 95 per cent probability. More extreme movements would happen with a 5 per cent probability.
Over a period of 84 days, roughly speaking, we'd have expected this 95 per cent range to run from -8.6 per cent to +8.6 per cent. Compared with that, a 12.1 per cent move is a bit unusual.
It's only a bit unusual because the historical volatility of the INR/USD, in the period of the float, was rather low. The USD/EUR rate, which is perhaps the world's most liquid market, has had an annualised volatility from January 1999 onwards of 10.3 per cent. The INR/USD has got to surely be more volatile than this, given the inferior liquidity of the INR and given the greater macroeconomic volatility in India. Hence, I think we should consider the 9 per cent vol, that was seen in the early days of the float, as relatively unusual. The future will most likely hold bigger values for this vol.
The implied volatility of the INR/USD at the NSE has reared up to values like 14 per cent annualised. That sounds more sensible to me.
What about other currencies?
We tend to do wrong by focusing too much on the bilateral INR/USD rate. In the recent days of distress, as fear has resurged, people have taken money out of everything under the sun and put it into US Treasury bills. This has given a strong dollar at the expense of essentially every other currency. Here's the picture for the INR, against the four major currencies of the world, from 1 July till 22 September:
|1 July||22 Sep.||Depreciation|
The picture of the rupee is much more complex than that implied by simply watching the bilateral rupee/dollar rate.
Can RBI block such a large depreciation?
Let's think through the steps which would follow if RBI tried to sell dollars in trying to prop up the INR:
- Global trading in the INR stands at roughly $75 billion a day. If you want to manipulate this market, you need a big stick. Small trades will do nothing. If preventing INR depreciation is the goal, RBI has to go into this with trades of $2 to $5 billion a day, with the willingness to stick it out for the long run. With reserves of $281 billion, there is not much hope here. Specifically, if RBI sells $80 billion in reserves, the market will see that. They will know that further rupee defence is now going to be hard (since $200 billion of reserves is starting to look like a small hoard), and speculators across the world will start betting that RBI's defence of the rupee will fail.
- Reserve money is only $275 billion. For each $27.5 billion that RBI sells, reserve money drops by 10%. At a difficult time like this, a sharp and sudden monetary tightening will be an unpleasant side effect of defending the rupee. (This trading can be sterilised, but that has its own problems. I just want to emphasise that selling reserves is not easy and is not a free lunch).
- The rational speculator knows that the exchange rate will eventually find its level. When RBI prevents a large INR depreciation today, they are giving a free lunch to the speculator, who would take a bet that INR would depreciate in the future. Specifically, it would be efficient for domestic and foreign investors to dump assets in India, take money out at (say) Rs.45 to the dollar which is the artificial price, wait for the gradual depreciation to Rs.50 to the dollar, and come back into India to buy back the same assets. This trade generates 11% returns over a short period and is thus very attractive. In other words, a defence of the rupee would trigger off an asset price collapse in India.
Meddling in the affairs of the currency market is thus highly ill-advised for a central bank.
Should RBI try to block INR depreciation, even if they could?
Let us play a thought experiment where RBI had $2810 billion, i.e. 10x larger than what's with us today. In that case, RBI could play in the currency market, selling $2 to $5 billion a day for a year without serious distress. Is this a good idea?
I would argue that this is not a good idea. When times are bad, the rupee should depreciate. This drives up the profit rates of all Indian tradeables firms and thus bolsters the economy.
Under a floating rate, in good times, the INR appreciates (which pulls back the exuberance of tradeables) and in bad times, the INR depreciates (which fuels profits and thus the physical investment in tradeables). This is arguably the only element of stabilisation in Indian macroeconomic policy.
RBI is playing this mostly right
From early 2007 onwards, the INR has been quite flexible. In particular, after early 2009, RBI's trading on the market has tailed off. There have been a few months with minor amounts of trading by RBI. This trading has mystified me, since these small trades can do nothing to influence the price. In practice, the INR has been a float.
A floating exchange rate is exactly the right stance for difficult times like this. In bad times, the best thing that can happen for India is a big INR depreciation, thus bolstering the tradeables sector.
Let's evaluate an alternative policy platform: To peg the INR in normal times but to let go in difficult times. Is this feasible? Yes. But this is very disruptive: if economic agents have been given an implicit promise that the INR will not move, then the large move (which will surely come) would cause pain. It is far better to stay out of the market all the time, and create a trustworthy structure of expectations in the minds of economic agents about what the future holds.
We had a large depreciation in the crisis of 2008, and that served India well. In similar fashion, we should welcome the INR depreciation that is accompanying global gloom.
The only element of RBI policy where I have a major disagreement is communication. RBI has never used the words floating exchange rate. RBI needs to clearly communicate to the economy that the rupee is now a market determined exchange rate, and RBI is no longer in the business of trading in this market. There is greater clarity of thought at RBI as compared with the quality of communciation; the speech writing still suffers from twinges of 1960s economics.
What is the collateral damage of a large INR depreciation?
There are three things that go wrong alongside a big INR depreciation:
- Firms who have unhedged foreign currency borrowing get hurt,
because they have to pay back more than anticipated. A person who
borrowed Rs.100 (in unhedged USD) has to pay back Rs.110, owing to
the 10 per cent INR depreciation. The stock market is doing a fine
job of identifying these firms and beating down their stock prices.
Of crucial importance is the fact that from early 2009 onwards, the INR had already moved to a float with a 9 per cent annualised vol. So CEOs and CFOs knew that the INR/USD rate was going to fluctuate. They were not lulled into complacence thinking that the exchange rate was going to be stable. By avoiding this moral hazard associated with pegged exchange rates, RBI's decision to float in early 2009 laid a good foundation for the structure of firm borrowing as of July 2011.
When a country has a pegged exchange rate, you tend to see a big buildup of unhedged currency exposure on corporate balance sheets. When the big depreciation comes, the big businessmen then queue up to the central bank begging for defence of the LCY. Prevention is better than cure: It is far better to have high exchange rate volatility all along, so that firms do not undertake such risks, and the toxic political economy does not come into play.
- With an INR depreciation, tradeables become costlier. On one hand, this bolsters the profitability of tradeables firms, and thus their investment plans. But at the same time, this feeds into inflation. In recent months, tradeables inflation has been sleeping while non-tradeables have contributed to the high CPI-IW inflation. We will now see a resurgence of tradeables inflation. This will exacerbate the inflation crisis. RBI will need to stay on the project of raising rates in order to combat this inflation.
- The government's subsidy program with petroleum products and fertilisers gets costlier when the INR depreciates. So India's fiscal crisis gets a bit worse when the INR depreciates.
This logic is rooted in high levels of de facto capital account openness. Sometimes, policy analysts think that you can have your cake and eat it too, and try to dodge these arguments by utilising capital controls. This has not worked in India, and the levels of de facto openness have only grown through the years.
In summary, what should RBI be doing?
RBI should be focused on using the short-term interest rate as a tool to bring CPI-IW inflation under control, without distortions of interest rate policy caused by trying to meddle in the currency market. This should be accompanied by liberalisation of the Bond-Currency-Derivatives Nexus so as to achieve an effective monetary policy transmission. These are the two things that RBI needs to focus on.
India shifted away from government interference in the currency market, from 2007 onwards but particularly after 2009. This is one of the biggest achievements in India's economic liberalisation. This is a bigger issue in economic liberalisation than (say) decontrol of petroleum product prices. The INR is now a market. Nifty and INR are the two most important markets in the economy. It is time for all of us to analyse the INR as we analyse Nifty: as the outcome of a market process.
Is RBI back to trading the INR?
We don't know. The data only comes out at monthly resolution, with a two month lag. But early signs that would show up would be unusual jumps in the weekly data about reserves, reserve money, etc. Greater transparency from their side would help greatly.