Fundamentals or market expectations - the challenges facing the rupee

It's been sometime since I blogged on the Indian economy. But the current travails of the rupee is a teachable moment. Following the trends, one cannot but get the impression that the fundamentals of the Indian economy, while doubtless a matter of great concern and showing little signs of any sustained improvement, may not be the trigger or even the most important reason for the current decline in rupee. However, sustainably addressing the medium-term fortunes of rupee will depend on resolving the fundamental problems facing the economy.

On the immediate problem, Jahangir Aziz hits the nail on the head when he writes,

It has been ridiculously cheap over the last month to borrow rupees at the overnight rate, buy dollars and then wait for the exchange rate to crumble. In June, the monthly overnight interest rate was 0.5 per cent and the depreciation 10 per cent.

As he writes, nothing  new about the Indian economy's fundamentals and expectations about it, which was already not priced in, has emerged in the past two months for fundamentals to be the driving force behind the recent decline of the rupee. Further, the dollar has been steadily rising against all these currencies since mid-May, as expectations of an end to the US Fed's quantitative easing began to harden.



In fact, the best evidence of this being the driving force behind the recent emerging market currency depreciation was the relatively muted reaction of the foreign exchange markets in the immediate aftermath of the decision. They even appear to have settled down (in comparison to its lead up) in recent weeks.

About the mechanism of shock-transmission, in the aftermath of the Fed's announcement on tapering of QE, long-term rates in the US rose, Jahangir Aziz again writes,

It is true that the rupee depreciation was triggered by the global shock, but what has extended the bleeding is self-propagating expectations of rupee weakness. Key to this expectation formation has been the market's belief that the RBI won't step in to draw a line in the sand. Fulfilling the market's expectations, the RBI hasn't, letting rupee dynamics be taken over entirely by the market's fears and greed...

With the interest differential with the US narrowing and renewed fears of the rupee depreciating, foreigners first began selling bonds... With the authorities doing nothing in response, the debt outflows surged and the rupee depreciated further. Equity investors, who till recently had shown remarkable resilience, joined the exit once their fears of policy inaction were confirmed. The rupee went into free fall, with almost the entire market taking a one-sided bet against the currency. The key to the free fall was the absence of a line in the sand. 

In the words of Mr Aziz, the "choice of policy inaction" has become the "driver of rupee dynamics". This is not to refute the theoretical wisdom about rupee finding its true value. True, the persistence of high inflation and large current account deficits (the $25 bn gap, as JP Morgan's Sajjid Chinoy writes) had been continuously eroding the value of rupee for some time. Policy needs to pursue that objective, but at the appropriate time. But, as the aforementioned graphs show, the current downward drift appears driven not by fundamentals but by market expectations. Now, with market expectations about rupee not anchored, the more urgent priority is to reshape expectations and re-anchor rupee.

The RBI has been belatedly aggressive in its response - tightening money available (by capping  its window for banks' overnight borrowings at 1% of total deposit base of all banks, or Rs 75000 Cr), selling bonds worth Rs 12000 Cr in the secondary market to suck out liquidity, raising the Marginal Standing Facility (MSF) rate for emergency borrowings by banks from 8.25% to 10.25% (it is usually anchored at one percentage point above the repo rate, currently 7.25%) - all aimed at squeezing liquidity and making it expensive for banks to indulge in rupee-dollar carry trade (short the rupee by borrowing rupees cheap to buy dollars and close the position when the rupee falls as anticipated). This follows earlier measures by both RBI and the SEBI to cut the liquidity available for currency speculation. Taken together, they amount to a virtual rate hike. The good thing about this is that, instead of the usual baby steps, this is a very decisive signal of the central banks' intent.

Has the RBI done enough to catch up with the curve? Or does it need to go further and raise rates to satisfy the markets by more credibly signaling its commitment to defend the currency? This dilemma has no theoretical answers. The preference would be to avoid rate hike and a quick reversal of the liquidity tightening, so as restore growth conditions. The best course would be for the Central Bank to wait and see how things move in the build up to its credit policy review meeting later this month. In particular, how the markets will respond to the steps taken to backstop the rupee's slide will be of utmost importance. Similarly, if the other emerging economies will follow Brazil and Indonesia and raise rates, the pressure on RBI to follow suit will rise.

This reversal of monetary policy priority from loosening to tightening is a testament to the difficult situation faced by the Indian economy. The current tightening can reasonably be expected to be a temporary measure. So its impact on growth is not likely to be very adverse. However, there are stronger headwinds ahead, especially when the Fed actually starts tapering, sometime later this year, and the US economy too starts showing more promising recovery signals. Then if inflation and current account deficits are still not brought under control, the Indian economy will be even more vulnerable. Unfortunately, this period will coincide with the build-up to elections and a lame-duck government, and the strong possibility of a hung Parliament and resultant political instability. Navigating both domestic and global headwinds in the year ahead will be extremely challenging.