RBI communicates dollar/rupee shift

Globally, central banks place a lot of emphasis on communicating with the financial markets and with other economic agents.

These communication exercises take the form of speeches, articles and interviews in the media explaining or, at least, trying to explain their objectives, policy measures and strategies. Communication is critical as it can potentially do half the job of the central bank. Proper communication can influence expectations about economic performance in an ensuing period.

Expectations about economic performance will influence economic agents' behaviour in the current period which is what will actually determine economic performance in both the current and ensuing periods!

For example, if people believe or expect that inflation will be high in the ensuing period, they will incur enhanced consumption expenditure in the current period to beat the oncoming fall in the purchasing power of their money.

Similarly, expectations of higher inflation can drive higher investment expenditures in the current period as entrepreneurs hope to benefit from lower “real” interest rates in the succeeding period(s).

Higher nominal interest rates — and consequently higher real rates — are not desired in that environment. (The recent requests to the RBI to pause or even roll back its monetary tightening can be well understood in this context).

On the contrary, if economic agents believe that inflation will fall in a subsequent period and that the central bank would ensure such an outcome, their current behaviour would factor in such an eventuality. Consequently, current or near period economic outcomes too will be influenced.

Consumption expenditure, for instance, could be postponed if people believe that the purchasing power of money would be largely stable.

Again, project expenditure proposals need not assign too much of importance to how inflation will evolve in the ensuing period.

In essence, inflation would not be a factor significantly influencing (current) consumption or investment decisions in the economy. It will be stable (and preferably low) enough to not be a material factor in economic planning.

But, proper communication is not easily done. For communication to be effective, it is obvious the financial markets and all other economic agents are able to fall back on a track record of the central bank “walking the talk”, so to say. The central bank should back what it says with good money and there should be a history of doing that.

Dollar/Rupee communication: Some way to go?

In this context, the Reserve Bank of India's communication exercises with respect to the dollar / rupee exchange rate and how that rate has evolved in the past few months are an interesting study in central bank communications and how they can influence market behaviour.

As is well known, the rupee has fallen some 15 per cent in the space of the past 3 months. Both the speed and magnitude of the fall have caught most market participants unprepared and in many cases even unaware. Even the biggest companies — in both the manufacturing and services sectors — have been blindsided by the size and speed of the move in the currency.

In the corporate sector, it is either a sudden, sharp rise in rupee outlays (on imports or on debt servicing) or significant opportunity losses on exports / other foreign exchange receivables.

In this backdrop, the requests to the RBI to intervene in the currency market and bring about some “stability' is not hard to understand.

In response, the RBI has pointed out that its role in the foreign exchange market is confined to smoothing out high volatility price moves and that it does not target any particular rate or level for the rupee's exchange rate. In other words, market demand and supply will determine the level of the rupee with the central bank intervening only to iron out excessive price moves in short periods of time.

As for the increased burden on imports/ debt servicing or the opportunity losses incurred, the RBI has pointed out that economic agents should make more active use of the set of available hedging instruments — both OTC and exchange-traded.

Well, the corporate sector may wonder if a 15 per cent price move in a span of 3 months does not qualify for being an “excessive price move in a short span of time”.

One cannot blame them completely for holding on to such expectations or hopes. For a long time now, active RBI presence in the local FX market has been taken as a given.

The massive rise in the country's FX reserves — from as little as $40 billion in March 2001 to as much as $300 billion at the onset of the financial crisis in September 2008 — was brought about only by large purchases of foreign exchange in the open market by the RBI.

Having got used to such intensive central bank presence in the markets for a long period of time — of course, only in one direction — economic agents possibly thought that the RBI would be present – even if not to the same extent - when the rupee moved in the other direction too.

Interestingly, this expectation or hope was belied even in the immediately post-Lehman period in late 2008 / early 2009. The rupee fell some 25 per cent in the space of 3 or 4 months in late 2008 / early 2009.

As the accompanying chart shows, the rupee moved gradually between mid 2002 and mid 2008 – rising from 49 to the 40 levels against the dollar. From those levels, it was mayhem in late 2008 / early 2009 in the environment of extreme risk aversion post Lehman Brothers. (The strain on corporate balance sheets caused by that large FX price move is well-known).

Once the dust settled, the rupee resumed its steady appreciating trend — rising from 50+ levels to the 45 levels in the past two-and-a-half years.

Another bout of risk aversion in global markets has now seen the rupee again losing value rapidly.

One key takeaway for corporate financial risk management about the dollar/rupee market from the history of the last 10 years is that volatility gets clustered in this currency pair. There are long periods of relative stability which are followed by concentrated bouts of volatility.

This is somewhat unlike the global currency majors where 2 or 3 per cent price moves occur very frequently. The Euro, for instance, may start at 1.33 on January 1 and end at 1.33 on December 31, but in the interim period, it would have moved all over the place. (see charts)

What is the message?

It is interesting that the RBI's communications about a somewhat hands-off approach or policy with respect to the dollar /rupee market has not been assimilated well.

Be it as it may, it may well pay for the corporate sector to “listen” to RBI communications on this subject more closely in the future. Indeed, the RBI has been quite consistent in stating that it does not target any particular rate level or range for the rupee. This message has been particularly drilled through in the past couple of years at every available opportunity.

The key communications test though will come when the dust settles on this latest phase of risk aversion in financial markets.

(The author is Vice-President (Economic Research), Shriram Group Companies, Chennai. Views are purely personal.)

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