Friday, September 23, 2011

What in the world is happening to the rupee?

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.

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 (per cent) USD 44.585 48.821 9.50 EUR 64.804 66.103 2.00 JPY 0.553 0.636 15.01 GBP 71.720 75.481 5.24

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.