The Hindu Business Line : Dynamics of the rising rupee

The rise of the rupee has been unprecedented. It rose by more than 10 per cent against the US dollar, the euro, the British pound, and the Japanese yen in less than three months. A look at the economics of the rising rupee.

The recent sudden and fast appreciation of the rupee has many economists, bankers, and treasury managers running from pillar to post to find answers. They want answers to, first, what happened, then why and how and, lastly, what will happen down the road.

The rise of the rupee has been unprecedented. It rose by more than 10 per cent against the US dollar, the euro, the British pound, and the Japanese yen in less than three months.

That, in international currency markets, can literally lead to a feeding frenzy because of the herd effect such appreciations bring along. This sudden and speedy appreciation was, even by the standards of the Indian rupee (a currency that is fraught with volatility), a surprise. While there were general forecasts that predicted a strengthening of the rupee against the dollar when it was in the 44.50-45 range, no one ever thought it would be that fast or this sudden.

The Reasons

When it comes down to the reasons for this appreciation, many put forward. There have been accusations that the Reserve Bank of India is pandering to the Finance Ministry by letting the rupee appreciate so as to bring down inflation. Then, there are more reasonable explanations that the appreciation is because of the increased demand for rupee, a result of massive capital inflows.

Charts 1 and 2 show the movement of the rupee against the dollar and the yen over two different time periods. Chart 1 is from January 2005 to the present, while Chart 2 is from January 2007 to the present. Chart 1 shows the massive volatility of the rupee against both the currencies but what really stands out is its recent appreciation.

Chart 2 shows that appreciation in clearer detail. The rupee started to clearly strengthen against the dollar and the yen on March 5 (the area that is circled). Between then and June 5, the rupee strengthened by 10.5 per cent against the dollar and it strengthened 16.4 per cent against the yen between March 5 and June 1.

Exchange Rate Economics

Before we explore the dynamics of the rupee movement, it may be worthwhile looking at some economics on how and why a currency moves against others.

The currency of any country is set on the basis of demand and supply, much the same as any commodity such as oil. All major currencies are set based on trading in exchanges and the higher the demand for a commodity, the stronger it becomes and vice-versa.

However, some currencies are not traded on international exchanges, such as the Indian rupee. In such cases, the value of the currency depends of inflows of money from other countries/sources.

Capital inflows that come into the country are in the form of foreign direct investment, portfolio inflows (foreign money that is invested in equity), External Commercial Borrowings by Indian companies, remittances by non-resident Indians, and many other sources.

Therefore, when there is strong inflow of the above, the rupee will appreciate and vice-versa.

Another way a currency can appreciate is if it has a big trade surplus (when exports are more than imports) as there is a greater demand for the local currency because exporters have to change their foreign earnings into the local currency. However, the above only happens when a central bank of country does not intervene in the currency market and manipulate the level of the currency.

These exchange rates of these currencies are known as `floating exchange rates' because they move as result of regular market actions. Countries that typically do not intervene in the currency markets are the UK and the US.

However, central banks of Asian countries, such as India and China, do not suffer from such compunctions. The central banks in this region regularly manipulate the level of their currencies. The most egregious `offenders' have been China and Japan; both have expended billions upon billions to depress the level of their currencies. These currencies are called `managed currencies' or `partially floating currencies' for obvious reasons.

The central banks of these countries artificially depress the value of their currencies in order to become more `competitive'. They become competitive because their artificially cheaper currency makes goods produced in their countries cheaper vis-à-vis those of other nations and that has the potential to boost their exports. China is case in point. This type of manipulation of currencies is also known as `mercantilism' whereby a country manipulates its currency so as to promote trade.

Fixed Currencies

Then there are the `fixed currencies'. They are fixed by design. Usually a country will anchor its currency against a set value of another country's currency and will do anything and everything to maintain this value. This is also known as `pegging'. This policy is followed for several reasons and one of them is the mercantilist reason. Another reason is to combat inflation.

The theory behind this is that if a currency latches itself on to another one, the central bank of the latching country is forced to mimic the responsible monetary policies of the `latchee' country.

Since this ensures better monetary policies, it is presumed that it will lead to lowered inflation rates though that is a matter of debate. Some countries also fix the value of their currencies against a `currency board' which consists of several currencies.

Every country has an exchange rate policy and India is no different though the RBI has never admitted that apart from saying that it intervenes in the currency market to `smooth out volatility'. Anybody who follows the rupee and the Indian currency market knows that this is not quite so. The RBI has time and time again intervened in the currency market but it never on the scale of its counterparts in South-East and East Asian countries.

As Dr Rakesh Mohan, an RBI Deputy Governor, in a recent speech, said: "Our exchange rate policy in recent years has been guided by the broad principles of careful monitoring and management of exchange rates with flexibility, without a fixed target or a pre-announced target or a band, coupled with the ability to intervene if and when necessary, while allowing the underlying demand and supply conditions to determine the exchange rate movements over a period in an orderly way.

Subject to this predominant objective, the exchange rate policy is guided by the need to reduce excess volatility, prevent the emergence of destabilising speculative activities, help maintain adequate level of reserves, and develop an orderly foreign exchange market."

Studies done to find out what the RBI targets have concluded differently. Some say that the RBI targets the nominal exchange rate (the regular exchange rate) while some say that the RBI targets the real exchange rate (the regular exchange rate adjusted for inflation). Some others say that the RBI targets the nominal effective exchange rate' but some say it is the real effective exchange rate'.

Whatever the RBI targets, it is very clear that the central bank does not like the rupee to get too strong because of the likelihood that it will affect exports. However, given the strong capital inflows into India in the recent past, there has been strong pressure on the rupee to appreciate.

Thus, the RBI periodically intervenes in the currency market to ease the pressure. To do so, it simply sells rupees in lieu of dollars and this usually takes the pressure off. However, the caveat is that it can only do so when the pressure is moderate otherwise it will have to expend huge amounts.

Expanding Base

However, when the RBI intervenes in the currency market by selling rupees, it creates another problem. The dollars that it gets enter the monetary base (high-power money supply) and this obviously leads to the base getting bigger. When this happens, considerable inflationary pressure mounts on the system because it becomes a case of `too much money chasing too few goods'; the definition of inflation.

Therefore, to stave off this potential inflation, the RBI — any central bank for that matter — resorts to a tactic known as `sterilisation'. As the word implies, the RBI sterilises the rise in the money supply. For example, if the exchange rate is $1= INR42 and the RBI sells Rs 4200 crore, it receives $1 billion.

To ensure that this $1 billion does not lead to a rise the money supply, the RBI issues bonds for exactly Rs 4200 crore and sucks out that amount out of the system. As a result, the money supply is the same as before the intervention. This is known in the business as a `sterilised intervention'. The bar graph, which represents the cumulative MSBs (Market Stabilisation Bonds) sold, is rising as the exchange rate level is appreciating. This means that the rupee appreciated willy-nilly as a result of capital inflows. The RBI did its best to contain the rise of the rupee, as is evidenced by the rise in the MSBs. This rise is even more pronounced in early March 2007.

On March 2, the number of outstanding MSBs stood at Rs 43,734 crore and this doubled to Rs 86,306 crore by June 8, reflecting the massive capital inflows. However, what is interesting is the dip is the MSBs towards the end. This is because the RBI started rethinking the policy on the MSBs and sterilised less.

There is a good reason for this. When the RBI sells MSBs, it has to pay a certain rate of interest on those bonds. Selling all those bonds makes sterilisation an incredibly expensive exercise, some thing the RBI is not keen to bear.

(The author is Economist, Murugappa Group. The views expressed are personal. Send in your queries on economics to Whackonomics@gmail.com)

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