From ‘Bernanke put’ to ‘RBI put’

Globally, a “free put option for financial markets investors” is a perception and a concept made famous, first by Alan Greenspan and in more recent times by Ben Bernanke.

But, it seems that free put options for investors are available not only in Greenspan’s and Bernanke’s world. Emerging market economies such as India also seem to be quite generous to them.

Indeed, India also appears ready to (continue to) provide investors free put options, if the RBI’s recent statement on foreign exchange (FX) market intervention is any indication.

Speaking at the IMF recently, the RBI Governor said that to prevent local currency appreciation when capital inflows are large, central banks can intervene without limit as countries can print their own currency at will.

To be sure, the Governor was only reiterating a policy approach India has followed in the last decade. Between 2000 and 2010, India’s RBI conducted massive intervention in the domestic foreign exchange market, printing away rupees to the tune of some Rs.12,00,000 crore – approximately the rupee equivalent of the $300 billion of FX reserves accumulation.

Intervention – Does it help?

But is FX market intervention an effective way to prevent local currency appreciation?

One cannot be sure. An analysis of the issue shows that intervention may neither slow down nor reverse the direction of the capital flows.

Instead, it may provide strong incentives for further large capital inflows, which would call for more intervention.

Assuming that countries such as India cannot carry on the policy of “printing their own currencies at will” indefinitely because of other adverse consequences, one has to see if alternatives are available.

Why is market intervention in the face of large capital flows not likely to be an enduring solution?

That is because it effectively provides a put option to foreign investors.

Not only will their local currency returns from asset markets be boosted, those returns will also be enhanced (not merely hedged against currency risk) by the stability which the RBI’s intervention will create in the FX market.

A put option guarantees a selling price to an investor, thereby protecting his returns or minimising loss. By the same analogy, one can see that FX market intervention guarantees returns for the foreign investor.

The put option (guarantee) to foreign investors operates through a two-stage process.

In the first stage, the large local liquidity which intervention will create (despite attempts at sterilisation) will find its way into the domestic economy – boosting asset markets, demand for goods and services and nominal incomes.

MACROECONOMIC EFFECT

It is easy to visualise the boost to the pricing power and earnings profile (of the corporate sector) this momentum in goods and services demand/higher nominal incomes will provide. Robust corporate earnings then will easily spill over into booming stock markets.

There is nothing earthshaking here. This has been the story right through the last 10 years.

Just compare the trends in corporate profitability post and prior 2000.

A relatively higher degree of stability in the currency market then provides the icing on the cake for the foreign investor. This is the second stage of the put option.

In other words, if you decompose foreign investors’ return into a combination of returns in local currency terms and volatility in the local currency, both these components would behave exceedingly well – from the investors’ point of view.

For the record, the average annual returns on the Nifty index in rupee terms were around 15 per cent between 2000 and 2012. The returns in dollar terms were nearly the same – give or take a few points.

That is not surprising – since the rupee’s volatility was kept low by RBI intervention.

Despite the mayhem in the past couple of years with the rupee losing some 25 per cent of value in a short span of time, it is a relatively stable currency over the long term.

In the last decade, for instance, on a mean rate of Rs.46.50 to the dollar, the rupee’s 95 per cent probability range was 40 to 53. This means that in a worst case scenario, the foreign investor would lose some 15 per cent on the currency (FX risk) when he is generating 15 per cent returns in local currency terms. ( The volatility pattern in the rupee is different from other global currencies and relative stability does not mean zero FX risk).

The other situation

But, will non-intervention help? It well could. How?

Non-intervention implies no put option is available for the foreign investor. Again, in a two stage process, one can see that.

Local currency returns could be lower and get more volatile as corporate earnings would be under strain.

The indirect monetary tightening which currency appreciation implies, combined with direct import competition, can be expected to undercut earnings growth in the corporate sector as pricing power comes under pressure.

One can think of a whole range of industries – autos, commodities, chemicals, FMCG among others– where this pressure on pricing could operate.

Also importantly, the foreign investor does not have a free ride on currency risk hedges.

At higher levels of the rupee, he has to exercise greater judgment in deciding if (further) exposure would provide returns commensurate with the risk.

Steep rupee appreciation during a phase could slow down subsequent inflows as investors may prefer both a lower rupee and lower stock markets for considering further exposure.

In other words, it is reasonable to expect the development of a natural balancing mechanism – both in the FX and stock markets – as investors weigh the costs and benefits of Indian exposure on a dynamic basis.

The author is a Chennai-based financial consultant.

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