The volatile rupee

Something strange is happening in India's external economic relations. The rupee has found itself a new low level in relation to the US dollar and the British pound, and seems likely to depreciate even further.

A year ago, the Indian rupee stood at a then strong Rs 44.5 to the dollar. At that level, the rupee had appreciated by more than 13 per cent vis-a-vis the dollar over the preceding 13 months.

But between August of last year and the middle of December the value of the rupee fell to Rs 54 to the dollar, or depreciated by as much as 21 per cent.

Between December and early March this year, the currency regained some of its earlier strength to touch Rs 49 to the dollar.

But it has once again lost value and currently is above Rs 52 to the dollar, and possibly heading to its December low.

This raises the question as to why the rupee is showing signs of growing weakness. Open doors to foreign financial investors are known to generate currency instabilities and crises in most developing economies.

While India has side-stepped crises of this kind after 1990, it has periodically faced difficulties in managing the rupee in the face of such flows.

Foreign capital inflows

This seems to be true in the recent period as well, but in a rather peculiar way.

Among the main forms of foreign capital inflows that can influence the availability of foreign exchange in the country are gross inflows of “direct investment”, which are considered to be of the long-term kind, and “portfolio flows”, which are considered to be more short-term and purely financial in nature.

If we consider the sum of both direct and portfolio investment inflows into India, RBI figures suggest that they stood at $62 billion in financial year 2007/08, collapsed to $28 billion during the year of global crisis 2008/09, and then bounced back to $70.1 billion in 2009/10, $64.4 billion in 2010/11 and close to $60 billion during the first 11 months (April-February) of 2011/12.

This points to a puzzle. If aggregate investment flows are seen as influencing the value of the rupee, the depreciation of the rupee in crisis year 2008/09, from less than Rs 40 to the dollar to Rs 52 to the dollar, is explained well by the figures, which point to a significant decline in the volume of capital inflows into the country during that period.

The subsequent appreciation of the currency to a level of about Rs 44 to the dollar by late 2010 is also in keeping with the increased foreign exchange inflow that the revival of foreign investment resulted in. What is not so easily explained is the subsequent depreciation of the rupee, including the current decline in the currency.

Speculative flows

What is interesting, however, is the observed strong relationship between movements in short-term, and therefore more speculative, portfolio flows.

Portfolio inflows stood at $27 billion in financial year 2007/08, a negative $14 billion during the year of global crisis 2008/09, implying an outflow in that year, and then rose to $32.4 billion in 2009/10 and $31.5 billion in 2010/11.

However, these short-term flows fell again to $18 billion during the first 11 months (April-February) of 2011/12.

Thus, if at all foreign investment flows can explain the fall in the rupee in recent months, it is only one component of such flows that could be held responsible: short-term financial flows.

One implication of this relationship between movements in speculative foreign capital and the depreciation of the rupee could be that changes in the value of the currency are being driven by speculative factors.

Whenever the Reserve Bank of India intervenes in the market to buy or sell dollars to counter the influence of such speculative forces, the rupee displays some stability. When it does not, the rupee tends to fluctuate sharply, being overwhelmed by speculation.

Consider, for example, the appreciation of the rupee that occurred when India experienced a sharp increase in capital inflows over the year before March 2011.

The surge was explained largely by developments in the developed capitalist countries, where financial investors had access to the cheap liquidity that developed country governments had pumped into the system in response to the financial crisis.

India was chosen as one of the favoured investment destinations by those investors.

Like many other developing country markets, India became a victim of the dollar carry trade, in which international players borrowed in dollar markets, where liquidity was ample and interest rates low, and invested in equity, debt and real-estate in developing country markets, where profit rates were high, in order to make huge profits from the differential between the cost of debt and the return on investment.

Sensex-rupee link

The result of such speculative activity was that the rupee's appreciation was also associated with a boom in stock markets driven largely by foreign institutional investment.

As a result of speculative investments in the market, the Bombay “Sensex” stock market index, which had lost much value during the global crisis, rose once again to touch the 18,000 level. The reason was clear. Net portfolio investment inflow into India had revived. Speculation had pushed up both the Sensex and the rupee.

Scanning the relationship between the level of the Sensex and the rupee's value over the last five years, we do find a noticeable relationship, with the rupee ruling high when the Sensex is high and settling at lower levels when the Sensex is down.

What is interesting, however, is that since early 2009, the “gap” between the level of the Sensex and the value of the rupee has widened, suggesting that factors other than the mere size of capital flows are affecting the rupee.

One possible reason for this enhanced volatility in the rupee relative to the Sensex, which it earlier tracked, could be enhanced speculation in the currency market.

To recall, India first permitted trading in currency futures (starting with Rupee-USD futures) on August 29, 2008. Subsequently, trading in currency options was also permitted.

It being an instrument settled at a future date whose value is linked to the exchange rate, the perceptions of participants in the futures market influence the spot price or the market exchange rate as well.

Participants include not just those who want to hedge their foreign currency exposures, but speculators who place bets based on their expectations of future trends. Their presence provides the necessary liquidity for the market to work.

What goes up…

As Chart 3 and 4 show, since 2009, there has been a huge increase in currency derivatives trading, both in terms of contracts and turnover. This sudden expansion of the futures market must have influenced movements in the rupee's value.

A March 2011 study, by Somnath Sharma of the Reserve Bank of India, did find indications that currency volatility had increased after the introduction of futures trading, though the noise generated by the global financial crisis made it difficult to establish clear causality.

But experiences such as the speculative attack on the pound sterling in 1992 (Black Wednesday) and in South-East Asia in 1997, suggest that speculation can play a role and, therefore, cannot be ruled out as an influence on a currency's value.

In this kind of speculative game what goes up will come down.

That is what seems to be happening now, with foreign speculative investors deciding that both the Indian stock market and the rupee are not such a good bet, resulting in a fall in portfolio investment and a depreciation of the currency.

The expectations this generates in futures market could be aggravating the decline in the currency.

One reason for this loss of confidence could be evidence of a worsening of India's balance of payments.

The rupee's depreciation is helping exporters, though some do argue that India's unusually good export performance in the face of a global slowdown could be the result of the over-invoicing of exports.

Import growth

However, the depreciation of the rupee has not resulted in any slowdown in import growth, despite the resulting increase in the prices of imports.

India's exports in 2011-12 rose to $303.7 billion or by 21 per cent, helped no doubt by the cheaper rupee. But simultaneously, imports rose by a much higher 32 per cent to $488.6 billion, driven substantially by imports of petroleum and gold.

As a result, India's trade deficit rose to a huge $185 billion in 2011-12, up from $130 billion in the previous year.

The demand for gold is also driven to a significant degree by speculative instincts, since rich Indians are looking for alternatives to stocks as investments.

So the widening trade deficit is also partly the result of speculation: domestically for gold and internationally for oil. When the trade deficit widens so sharply, speculative investors would expect that the rupee would have to fall to curtail imports and push exports, so as to help reduce the deficit. This could have triggered speculation based on expectations of the rupee's decline.

Instability of this kind is, by no means, good for the economy. While a weak rupee may be good for exporters because it lowers the value in dollars of India's exports, it also renders imports more expensive and contributes to inflation.

This effect has not been fully felt as yet because one set of imports whose cost can contribute to generalised inflation is oil and petroleum products.

Oil prices

International oil prices have risen sharply in recent months because of the political uncertainties in West Asia, especially the stand-off between an aggressive US and Iran. That price increase has not yet impacted the Indian people because the election season that concluded only recently forced the government to hold back on increasing the domestic prices of petrol and diesel.

But with this round of elections over, there are powerful forces within the government pushing for an adjustment of domestic oil prices to bring them on a par with international prices. If that is done, the increase would be substantial.

Rupee prices would have to be increased not only to take account of the increase in the dollar price of oil, but also the depreciation of the rupee relative to the dollar. The hike would be substantial.

Thus there is a real threat of an aggravation of inflation from its already high level.

A discredited Standard and Poor's rating system and capability should not be taken too seriously.

Hence the Finance Minister may be correct in saying there is no cause for panic because of its downgrade of India.

Unfortunately, investors do pay attention to ratings, including speculative investors. Having exposed itself excessively to such investors, India's government does have reason to fear further downgrades and further volatility.

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