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The Indian rupee fell below 68 against the U.S. dollar this week. There is no sanctity to that particular level, except that it reinforces the pressure the local unit has been under in recent weeks. So far in 2018, the Rupee has lost 6 percent, reversing gains it notched up in 2017. Sure, the Rupee’s weakness is not out of line with peer currencies in Asia, but at last count it was the worst performer in the region so far in 2018.
Understanding The Rupee Nervousness
The first point to take note of is that ‘permanent foreign currency’ flows into India have turned negative.
How do you define permanent foreign currency flows? One measure of such flows is the sum of our current account deficit, foreign direct investment, and foreign portfolio investment in equity.
This measure was positive between FY15 and FY17, but turned negative in FY18 – a trend that is expected to accelerate in FY19. Higher oil prices and tepid Indian exports could pressure the CAD, while global monetary tightening, domestic politics and global geopolitics could restrain capital inflows.
By some estimates, permanent foreign currency outflows could hit $45 billion this year, a level not seen since FY13.
If the declining level of permanent foreign currency flows is one issue for the Rupee, then the market positioning is another.
There is an overhang of accumulated long-Rupee positions and carry seeking positions in the market. Carry trade essentially involves borrowing in a currency where interest rates are low to invest in currencies where rates are high. A key determinant in the success of such a strategy is a stable or appreciating currency.
"" - The accumulated carry positions in the Indian market amount to about $120 billion between FY14 and FY18.
Such positions include:
- Foreign portfolio investments in debt: increased by $44 billion since FY14;
- Non resident deposits: increased by $37 billion since FY14;
- Selling by exporters;
- Unhedged foreign currency debt;
- Speculative positions betting on rupee appreciation.
At least some of these positions are nervous and exiting, adding to concerns over the permanent foreign currency outflows.
Given the dynamics in the currency markets, what, if any, should be the policy response?
The over-arching goal should be to increase permanent foreign currency inflows. Such inflows are better quality global savings that can be channeled into productive investments.
Inclusion In Global Bond Indices
One way to do this is to try and make foreign portfolio flows into the debt markets more permanent. This applies both to the existing stock of foreign portfolio money in the Indian debt markets, as also to the flow of fresh money.
The total outstanding foreign portfolio investment in Indian debt markets is just shy of $70 billion. These investments have proved to be far more stable in recent years compared to the rapid outflows seen in 2013. Yet, given Indian bonds are not part of global benchmark indices, there is always the fear that global portfolio managers may be forced to exit these holdings (which are not part of global benchmarks) at some stage.
"The RBI and the government should now announce – and follow up with honest effort – their immediate intent to work towards inclusion of local currency Indian debt into global bond benchmark indices such as those administered by JPMorgan Chase and Citi."
While the actual process of inclusion can take a long time, global investors can draw comfort from visible progress in that direction.
This would not just be a knee-jerk reaction to current market conditions. After all, we have announced our intent to open FPI holdings in government debt to 6 percent of total outstanding by 2022. As the quantum of FPI holdings in debt increases, making them more permanent is a long-term imperative. Other countries such as Malaysia, Thailand and Indonesia are already part of such indices, while China is on the brink of inclusion.
The REER Debate
The second policy priority should be to allow the real effective exchange rate (REER) to find a level which improves permanent flows. This is a contentious area, but one where a policy call needs to be taken.
The rupee’s 36-country REER touched a high of 121 earlier this year. While economists have argued that REER ignores productivity differentials over time, this was an indication that rupee was severely overvalued. The last set of market moves have brought down REER to 115, but the absolute levels are still elevated.
Researchers have suggested that a sizable portion of our exports is inelastic to the levels of the rupee. Even if we accept that contention, there is less research on the impact of the rupee on imports. It is at least a plausible hypothesis that a weaker rupee would curb our gluttony for Chinese trinkets, and help grow a domestic make-for-India manufacturing effort in time. A more reasonably valued rupee could even help foster FDI and permanent portfolio flows over time.
In short, there is a case to allow the REER to drop further. What the target could be (113? 108?) and over what time frame, has to be an internal RBI assessment.
Engineering this while ensuring markets do not overly panic will be a tricky operational test for RBI, particularly through ever-changing, nervous markets. This would call for astute and well-timed use of foreign currency reserves and intervention, appropriate verbal intervention and communication, and an over-arching show of being in control. There has to be reiteration of the basic truth - that while the macros could get even worse (what if oil heads to $100?), the RBI has enough in its arsenal across forex reserves and policy instruments to manage any eventuality.
Don’t Kill Volatility
It is also worth asking why such a large-sized rupee carry trade has built up since FY14.
There was comfort—and complacency—that the volatility-adjusted return from holding rupees would exceed the return from other currencies such as the U.S. dollars.
This, in turn, was a function of improving macro economic conditions, high real interest rates in India at a time of abundant global liquidity, and a perception that the RBI would limit forex volatility.
For now, the current bout of nervous exits has a silver lining – this can bring down the level of carry positions, while simultaneously correcting the REER. This will be a delicate market operation though – the RBI has to ensure that the carry trade sluice gates open just right so that levels reduce, with minimal cascading downstream damage.
In the medium term, RBI and the Monetary Policy Committee must review how India’s monetary policy framework and the RBI’s intervention methodology have contributed to the growth of this rupee carry trade over time.
"We need a better intervention framework than the current ostrich-like approach that purports that RBI does not target any specific rupee rate, and only acts to douse some unstated measure of volatility."
Such statements ring hollow, given the immense impact that monetary policy and RBI intervention policy has on foreign exchange markets and the external sector.
Stay Calm And Don’t Panic
While there are short and medium term issues to ponder, none of the above calls for any extra-ordinary, short-term, knee-jerk steps.
While market commentary has already started to list possible actions from past experience (such as a special forex window for oil importers, or a special swap window for foreign currency deposits etc.), I would argue that it is way too premature to consider any of this at this stage.
However, policy makers have to plan and prepare for all eventualities at all times, and brushing up on contingency plans is never a bad idea. While we still have the luxury of time, it would be sensible to review the efficacy and structure of some of the extra-ordinary responses of 2013.
For one, the monetary policy response of July 2013 was then seen as knee-jerk and ill thought out, and as an expensive experiment with unclear benefits.
Likewise, while RBI’s special swap window to encourage FCNR (foreign currency non-resident deposits) deposits was hugely successful in bringing in much-needed foreign currency at the time, the structure is worth revisiting. For those in the know, this scheme was pitched as one that brought in non-resident deposits. But, in reality, it brought in bank money in the garb of NRI deposits, giving low-risk, leveraged, high returns exclusively to NRI depositors and banks, while denying a similar swap opportunity to other eligible and productive foreign currency borrowers such as our infrastructure financing companies.
Ananth Narayan is Associate Professor-Finance at SPJIMR. and former head of global markets - South Asia, at Standard Chartered.
The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.
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