Rupee Appreciation: Should the RBI Act?

Rupee Appreciation Should the RBI Act

As FIIs flood Indian markets, the rupee strengthened to its most substantial level in almost two years on October 14. In the midst of an international investor buying frenzy, the rupee reached Rs 44.19 against USD. One-third of the Indian equity market has flown in since September, and foreign funds have already bought USD 21 billion. Banks and exporters continue selling the dollar on local markets to keep track of gains in local shares.

Why is this dollar deluge so ominous?

“In search of higher yields,” western bound funds have made a run for emerging markets like India. The return is much greater in these countries. The difference in interest rates between India and the US is “significant” and continues to grow (while US interest rates are at their lowest point, one cannot say that emerging markets have stopped allowing rate hikes in the US as they continue to fight inflation. These differentials, along with improved growth prospects, have led to capital flows to higher rates and increased the appeal of carrying trades (see graph). It is also beneficial for FIIs since they can repatriate fewer rupees when they convert it into USD.

The popular ex-ante measure of the attractiveness and risk of carrying trades is the carry-to-risk ratio. This adjusts the interest differential by the chance that future exchange rates will move. The expected volatility of the relevant currency pair is used to determine this risk.

If the rupee appreciates, will RBI or the government blink?

It is unlikely, at least not yet. The Finance Minister made it clear that there is no need for FII inflow caps at this point. He may be correct considering the following:

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1. The Q1 FY11 CAD numbers were higher than expected. The Q1 FY11 Current Account Deficit of USD 13 billion was three times higher than the quarter prior to Q1FY10. Annualized USD 55 billion is a risky figure. However, India received USD 20 billion in H1 2010, 2011, so the flows are well within their absorptive capabilities.

2. The government and RBI have been able to reduce the ‘imported portion’ of inflation through rupee appreciation. Despite the criticisms from the exporter community, RBI and the government have to choose between the best of both worlds.

3. The government also has what we call “sterilization,” which is basically buying back the excess rupee by issuing securities. Securities are released every time it sells dollars. The government can stop the appreciation of the rupee by doing this. The process comes with its “own costs.” Sterilization is not a good idea and will increase the burden on the RBI and government. The issue of securities would also entail high-interest outgo.

What does it mean for Emerging Markets, and why is the dollar falling?

The dollar is suffering against all major currencies. On October 13, 2010, the dollar fell to a 9-month low against a basket currency. It then edged towards a 15 year low against the Yen. This was due to expectations that the US Federal Reserve would have to continue quantitative easing. The massive deficit is also affecting the currency. The budget deficit for the year ended September was staggering at USD 1.47 trillion. Federal Reserve Chairman Ben Bernanke called for swift and decisive action to reduce the US budget deficit. He warned that failure to do so could lead to a severe crisis.

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The emerging markets, on the other side, have plenty to be concerned about. The US policymakers are concerned about the dragon economy, which has been causing havoc with US territory. Because USD 900 Billion of the USD 2.5 Trillion foreign exchange reserves in China are held in US Treasury. China is the largest holder of US government debt. Any instability in USD can wipe out Chinese foreign currencies. This is something India and China should be aware of, as well as the US Treasury.

 

 

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