The Travails of the Rupee

Apr 15th 2010, C.P. Chandrasekhar and Jayati Ghosh

The Indian rupee stood at a robust Rs. 44.4 to the dollar at the beginning of the second week of April. At that level the rupee had appreciated by more than 13 percent vis-a-vis the dollar over the preceding 13 months (Chart 1). This suggests that the Reserve Bank of India has not intervened in the market and bought up surplus foreign exchange to the extent required to relax the upward pressure on the value of the rupee and stall its appreciation. This reluctance could partly be because, given the relatively high level of already accumulated foreign exchange reserves, the central bank is finding it difficult to match the surge in capital inflows with new purchases.

Chart 1  >> Click to Enlarge

The surge in capital inflows is explained largely by developments on the supply side, with India being chosen as one of the favoured destinations by financial investors seeking to exploit the cheap liquidity that developed country governments have pumped into the system in response to the financial crisis. Further, like many other emerging markets, India is becoming a victim of the dollar carry trade, in which international players borrow in dollar markets, where liquidity is ample and interest rates are low because of anti-crisis measures, and invest in equity, debt and real estate in emerging markets, where returns are much higher, in order to profit from the differential between the cost of debt and the return on investment. This is a game that seems to especially attract international financial firms seeking to quickly recoup the losses they suffered in the recent recession.

That this kind of game is currently popular with respect to India as well is clear from the fact that the rupee's appreciation is associated with a boom in equity markets driven largely by foreign institutional investment, as a result of which the Sensex is courting the 18,000 level once again. Balance of payments data recently released by the Reserve Bank of India indicate that net portfolio investment inflow during April-December 2009 amounted to $23.6 billion, as compared with an outflow of 11.3 billion during the crisis months of April-December 2008 (Chart 2). The accumulation of reserves during the April-December 2009 period amounted to $31.5 billion. While valuation changes contributed to an increase in dollar reserve figures, the importance of portfolio inflows and central bank intervention in currency markets cannot be denied.

This process has since continued. According to figures from the Securities and Exchange Board of India, as of April 11, net investments by FIIs in debt and equity markets amounted to an additional $10.1 billion, during 2010. Seen in this light, the reluctance of the RBI to intervene adequately to absorb these inflows is understandable.

Chart 2 >> Click to Enlarge

This trend reflective of the dollar-carry trade feeds on itself for two reasons. First, it is well known that despite post-liberalisation buoyancy the Indian stock market is still both narrow and shallow. Narrow because there are relatively few listed companies whose stocks are actively traded. And shallow because the proportion of ''free-floating'' shares in these companies not held by promoters and available for regular trading is limited. As a result whenever there is even a minor surge in foreign institutional investment flowing into these markets, the demand they generate at the margin is enough to drive stock prices up quite quickly, widening the differential between the cost of borrowing and the return on investment and attracting further investments. This tends to generate a self-reinforcing and often speculative spiral of investment.

Chart 3   >> Click to Enlarge

Secondly, the expected return to the investor is even higher than this differential because as and when she decides to sell financial assets to book profits and repatriate capital to clear debts incurred at home, the appreciation of the rupee yields more dollars than would have been the case at the exchange rate when the investment was first made. This provides an additional return that justifies even more the speculative spiral and leads to further appreciation of the rupee.

The corollary of such rupee appreciation is of course a weakening of India's export competitiveness because the dollar values of the country's exports rise as the rupee appreciates. It is to prevent or moderate that outcome that central banks have to manage the exchange rate through open market operations, involving in this case the purchase of dollars and an increase in reserves. But if this increase in the assets of the central bank is not neutralised or sterilised through the sale of government securities, for example, then money supply to the economy increases. In the past the Reserve Bank of India had resorted to this option to retain its control over the pace of expansion of money supply. But with the inflow of capital having risen sharply and been quite high in most years of this decade, its ability to do so depended on rebuilding its depleted stock of government securities through special schemes like the Market Stabilisation Scheme which create their own problems. So the reluctance to intervene may be because of a decision to retain some degree of control over the monetary lever ignoring (at least for some time) the fall out for the rupee.

Whatever be the explanation for that reluctance, it is material only because as of now dealing with the source of the problem, which is the embarrassingly large and unneeded inflow of foreign capital for what are speculative investments, is not an option for the government and the central bank. Some other countries, like Brazil, have sought to deal with the recent surge with measures, however limited, that are directed at curbing speculative inflows. Since this would go against the grain of the ideology influencing economic reform, which includes the belief that maintaining a freer and more open capital account is the best option, the Reserve Bank of India that wants control over the monetary lever and is faced with a surge in capital inflows would have to tolerate rupee appreciation.

Chart 4   >> Click to Enlarge

But it is clear that the central bank cannot continue with this stance for long. India's balance of payments statistics point to high and persisting trade and current account deficits in recent quarters (Chart 3 and 4), and those deficits would only widen if international oil prices continue to rise. In these circumstances, even if the protests of exporters are dismissed, a process that renders exports more expensive in dollar terms and imports cheaper in rupee terms cannot be ignored. That is ''success'' on the capital account of the balance of payments cannot beyond a point be at the expense of a weakening of the current account and the domestic economy.

Further, rising inflation is forcing the Reserve Bank of India to turn its attention to what has always been its primary brief: using the monetary level to moderate price increases. One way in which it is expected to do this is by raising interest rates and reducing offtake of credit to cool an overheating system. But raising domestic interest rates would only encourage further those investors exploiting international interest rate differentials and engaging in the carry trade. Being relevant on the price management front may make the central bank an even greater failure with regard to exchange rate management.

The real option is, therefore, one of dealing with the source of the problem and using measures to control the inflow of financial capital, especially speculative capital. There are many policy options at hand to achieve this end. What is required is that a government that had perceived the surge in capital inflows and the accumulation of reserves as being indicators of economic success admits that even in its own framework this is proving to be too much of a good thing.


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