Indian Rupee
Continues to Fall
Should RBI Intervene to Arrest Rupee’s Relentless Fall?
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Rama Krishna Vadlamudi, HYDERABAD
14 December 2011
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In September 1998, Nelson Mandela wrote
to speculator-cum-philanthropist George Soros asking how South Africa
should deal with currency speculators like Soros himself. Writing back, Soros
said that it was always futile to defend any indefensible exchange rates and
instead urged the South African leader to avoid excessive short-term external
debt and to maintain stringent supervision over local banks.*
We do not know
whether South Africa
benefited from Soros’ advice of non-intervention in foreign exchange markets.
But, the Reserve Bank of India
seems to be following a hands-off policy when it comes to dealing with the
Indian rupee’s sharp depreciation against the US dollar since the second week
of August 2011.
Between August 2011
and now, the rupee has fallen by almost 20 percent against the dollar from a
level of 44.74 to 53.51. On 13 December 2011, the rupee touched an intra-day
low of 53.51 before settling at 53.23 at day’s close.
The sudden
depreciation has shocked many Indian companies and others engaged in foreign
trade, investment, etc. Importers and companies with external debt with
un-hedged exposures are caught unawares. Many Indian companies (net foreign
exchange spenders) declared high exchange losses during the July-September
quarterly results. The costlier dollar (versus the rupee) has made life
difficult for Indian travellers and students studying abroad.
* Source: “Soros – The Life and Times of A Messianic
Billionaire” by Michael T. Kaufman
The fear is that the
exchange losses for India Inc may continue during the current quarter
(October-December 2011) also.
Countries, like, Switzerland and Japan are grappling with currency
appreciation. But, in India
we are facing the opposite situation of a sharp depreciation of the domestic
currency against the US dollar.
What is troubling the rupee?
The current
depreciation of rupee can be attributed mainly to two factors: 1. external and
2. domestic. The external factor is the massive appreciation of dollar against
other major currencies, which caused short supply of dollars impacting the
value of rupee negatively. The domestic factors that worked against the rupee
are: slowdown in India’s
GDP growth rate, sharp deterioration of industrial activity as measured by IIP,
persistent inflation, growing current account deficit indicated by single-digit
exports growth and double-digit imports growth, political logjam on various
economic issues, rising fiscal deficit, weakness in stock markets, etc.
Basically, the rupee
fall is exaggerated by some sort of self-fulfilling
prophecy. The expectations of rupee falling to 50 were developing in August
2011 when rupee fell to 47. When it fell to 50 levels, experts predicted that
rupee would further go down to 52 levels. Now they talk of rupee touching 56 or
even 60 levels and the cycle goes on!
The empirical
evidence suggests that it is extremely difficult to predict levels in foreign
exchange markets. In July this year, everyone expected the US dollar to fall
further against other major currencies. But to everyone’s utter surprise, the
dollar has gained more than 10 percent in the last four months or so!
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Read more about the Indian Rupee:
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Should RBI intervene to shore up Indian rupee?
Amidst chaos and
large foreign exchange losses, a clamour has arisen from various quarters
demanding the RBI to intervene in the markets and stall the rupee’s free fall
against the dollar. In the past RBI intervened to either arrest the
appreciation or depreciation of rupee. As such, whenever some trouble arises,
there have been demands to RBI to protect the interests of the vulnerable
entities.
Between August and October 2011 when the
rupee depreciated from 45 level to about 50 level, the net sale of US dollars
was practically nil indicating the RBI’s non-interventionist policy. The official RBI position is: “We
don’t target a level of exchange rate. The exchange rate is determined by the
forces of supply and demand and other factors. We may intervene if there is
excess volatility.”
It is not
clear whether the RBI still thinks the 20-percent fall of rupee versus the
dollar is not “volatile” enough for it to intervene in the markets. If it has
to strengthen the rupee, RBI has to sell dollars, part of the government’s
official foreign exchange reserves, in the market. Opinion in the RBI seems to
be veering to the view that the country’s foreign exchange reserves are
precious and they have to be conserved for any future eventuality.
The RBI’s
figures show India’s
foreign exchanges reserves at $ 314 billion (Nov.11). Whereas, India’s total
external debt is put at $ 317 billion (Jun.11). While the total external debt
to GDP is comfortable at 17.4 percent (Mar.11), it is the share of short-term
external debt (within one year residual maturity) to total debt at 42.2 percent
(Mar.11) that is a big concern now.
The RBI
has kept its focus on taming inflation. India has experienced elevated
levels of persistent inflation for the past three years. To curb inflationary
pressures, RBI has raised interest rates 13 times (by 375 basis points or 3.75
percent) in the last 18 months. With the GDP growth rate in jeopardy now, the
general expectation is that the RBI may relax its monetary tightening. There is
also speculation that RBI may cut cash reserve ratio (CRR) for banks to improve
liquidity.
On 16 December 2011,
RBI is set to announce its quarterly review of monetary policy. Though food
inflation has come down to 6.6 percent, RBI may not give any indication of rate
cuts for the time being. Unless there are clear signs of inflation coming down
to the RBI’s comfortable level of five to six percent, RBI may not be in a
position to loosen its hawkish interest rate policy.
RBI has been
following ‘managed float’ exchange rate policy for several years. Managed float
is some sort of a via media between a floating rate system and a fixed rate
system. Depending on various factors, RBI tries to maintain some balance
between the extremes.
Currency Interventions of the Past
Interventions in the
past by central banks proved to be useless many a time. The famous instance was
the Bank of England’s attempt to defend the pound sterling. Their failed
attempt to defend pound in 1992 is said to have cost the UK Treasury more than
$ 5 billion at that time. After the 1992 bitter experience, there has been no
attempt either by the UK
government or the Bank of England to intervene in foreign exchange markets.
The billionaire
investor George Soros mentioned at the start of this article is credited as
“The Man Who Broke the Bank of England.”
His Quantum fund made a profit of $ 1 billion in September 1992 when the UK government withdrew pound sterling from
Exchange Rate Mechanism leading to 20-percent depreciation of the pound sterling
against the deutsche mark-DM, Germany’s
currency before the birth of euro. The currency speculators’ bets proved
correct and they made huge profits at the cost of reputation of UK and Bank of
England.
Surprisingly, the
pound recovered to its pre-ERM level of DM 2.95 per pound within a year. The
massive devaluation of pound seemed to have helped the UK economy as
the nation’s unemployment fell, growth accelerated and investment picked up
within one year of the ERM fiasco. Clearly, a non-interventionist policy worked
for them.
But, there are some
instances of central bank (and/or government) intervention working well in the
foreign exchange markets. The notable examples are G-7 action in March 2011 and
Plaza Accord of 1995. In March 2011, the US Federal Reserve in a coordinated
action with other Group of 7 (G-7) nations intervened in currency markets and
bought US dollars against Japanese yen to arrest the steep rise of yen (against
the dollar) after earthquake and tsunami struck Japan. After the G-7 action,
the yen fell from 76.25 to 81 level against the dollar in just one day. Prior
to G-7 action, the yen rose to 76.25 from 83 level. The intervention worked for
about three to four months.
Prior to 1995, the
US dollar was rising continuously against other major currencies. Discomforted
by the steep appreciation of the dollar, the US
government came to an understanding (at Plaza Hotel,
New York) with Germany,
France, Britain and Japan to arrest the over-valuation
of dollar. After this accord (known as Plaza Accord), the dollar underwent a
remarkable depreciation against other major currencies, in particular, yen and
deutsche mark. This had given a big boost to US exports in the following years.
Conclusion
The RBI seems to be
in a mood to conserve the precious foreign exchange reserves for any future
eventuality in the next few years. The eurozone sovereign debt crisis is yet to
unfold fully. If and when the eurozone breaks up (some experts are not completely
ruling out such a possibility), India may need the official reserves if there
is any further run on the rupee led by selling from the foreign institutional
investors in the Indian stock market.
As George Soros
commented in the beginning of this article, it may not be a good idea to defend
rupee which may cost the government heavily as had happened in the case of the UK’s
efforts to defend the pound sterling in 1992.
Strictly speaking,
we cannot compare India with
the UK.
The UK
has capital account convertibility and allows free movement of capital in and
out of the country. The same is not the case in India. India is following a very cautious
approach when it comes to capital account convertibility. Despite the
recommendations of two Tarapore committees, India still has kept lot of capital
controls in place in order to protect the domestic economy from external shocks
of the kind the world has witnessed in the past.
Due to the protected
environment, it is hoped that the currency speculators may not be able to give
big shocks to Indian rupee.
RBI is still giving
primacy to providing price stability at all costs over other policy objectives
of growth and exchange rate. Until inflation shows clear signs of waning, RBI
will continue with its tight money policy. It would be interesting to watch the
response of the Union Government if RBI continues with its non-interventionist
stance on dollar-rupee exchange rate.
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Abbreviations:
GDP - Gross Domestic Product or
national income
IIP - Index of Industrial
Production – a measure of industrial activity
Note on author: Author is an investment
analyst and writer. The views are personal and this is written only for
information purpose. The author has a vested interest in the stock markets.
Readers are advised to consult their certified financial adviser before taking
any investment decisions.
Author’s articles on financial articles can
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