Indian Rupee Continues to Fall

Should RBI Intervene to Arrest Rupees Relentless Fall?

Rama Krishna Vadlamudi, HYDERABAD 14 December 2011 www.ramakrishnavadlamudi.blogspot.com

In September 1998, Nelson Mandela wrote to speculator-cumphilanthropist 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 rupees 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 days 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, inIndia 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 Indias GDP growth rate, sharp deterioration of industrial activity as measured by IIP, persistent inflation, growing current account deficit indicated by singledigit 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 everyones utter surprise, the dollar has gained more than 10 percent in the last four months or so!
---------------------------------------------------------Read more about the Indian Rupee: Reasons for Indian Rupees Fall Stocks, Bonds, Rupee and Inflation Foreign Exchange Losses and India Inc

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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 rupees 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 RBIs non-interventionist policy. The official RBI position is: We dont 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 governments official foreign exchange reserves, in the market. Opinion in the RBI seems to be veering to the view that the countrys foreign exchange reserves are precious and they have to be conserved for any future eventuality. The RBIs figures show Indias foreign exchanges reserves at $ 314 billion (Nov.11). Whereas, Indias 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 RBIs 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 Englands 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, Germanys currency before the birth of euro. The currency speculators bets proved correct and they made huge profits at the cost of reputation ofUK 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 nations 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 overvaluation 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 theUKs 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, Indiastill 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.

Inflation isnt dying; we might be headed for stagflation

The drop in the Wholesale Prices Index (WPI) from 9.73 percent in October to 9.11 percent in November is the first sign that slowing growth and a good monsoon are finally denting inflation. But keep your fingers crossed. The official release also raised the September inflation figure to double-digits to 10 percent which means the November figure too could revised upwards when the provisional figures are corrected a couple of months down the line. Inflation isnt over. A closer look at the numbers tells us why.s The November figure of 9.11 percent is lower but not as low as expected by analysts because food prices have fallen after a good harvest. Winter is when food prices fall anyway. So it isnt quite a triumph of anti-inflationary policy or monetary action. But food and primary articles, which account for a weight of around 20 percent in the WPI, are the only things falling. They fell from 11.4 percent to 8.53 percent and made all the difference. Manufacturing and fuel and light, which constitute 65 percent and 15 percent of the WPI by weight, or nearly 80 percent, are still rising. In the coming months, they could make all the difference. In November, the inflation rate for manufacturing crawled up from 7.66 percent to 7.7 percent and fuel and light from 14.79 percent to 15.48 percent. Given that the rupee has been heading south since July, imported inflation and costs are bound to continue feeding the inflationary push in energy prices and manufacturing in the coming months unless international prices crash due to the eurozone crisis.

The prospects for inflation in the New Year depend on the following ifs. If the eurozone crashes, and oil and commodity prices, fall, inflation will continue to fall. If the rupee continues to fall, it may negate the fall in commodity prices and boost inflation. If the UPA persists with its Food Security Bill, even the downtrend in food prices may reverse in the second half of 2012. If the monsoon next year is not as good, it will fuel a further rise in food inflation. If growth continues to slow down, but cost pressures persist due to a falling rupee, we will have stagflation slowdown or stagnation with rising prices. If government revenues shrink due to the slowdown, the fiscal deficit will widen and build further inflationary pressures. Net-net: Dont assume that inflation is over. It has been weakened, but is definitely not dead or even dying.