The $/Rs exchange rate volatility: Looking ahead

The irreverent J K Galbraith once famously remarked that “the only useful purpose economic forecasting serves is to make astrology look respectable.”

Yet, the practice of forecasting remains fashionable. The response of the central banks to the biggest financial crisis since the Great Depression has permanently altered the way financial economics is perceived and digested, and the impact is telling on the most heavily-traded asset class – currencies.

After India graduated to a managed floating rate regime after 1993, the Reserve Bank of India (RBI) has played an active role in the forex spot and forward markets to keep the dollar-rupee exchange rate within the guided path of +2/-2% of the REER index.

The last two decades has seen several episodes of exchange rate volatility, the genesis and policy responses to which have been effectively captured by a paper by Anand Prakash. In the past couple of decades, institutional response to a rapidly falling (or rising) rupee has been a combination of monetary and fiscal actions; managing liquidity through the LAF and repo windows and throttling the knob on capital account transactions to curb speculative interests.

While past may not be the perfect guide to the future, it still holds useful instructions. At a time when the rupee is flirting with its historical lows, a dispassionate analysis of the post-liberalisation period could offer effective policy responses.

In an environment of partial capital account convertibility, the forex markets do not perfectly react to the interest parity principle and the equilibrium level of exchange rate is governed in large part by supply-demand dynamics. In the Indian context, this dynamic is watched closely by RBI, which intervenes to check volatility. A close examination of the 1993-2013 period indicates that the dollar-rupee rate is guided by the government’s fiscal deficit, current account balance, inflation, RBI’s forex reserves and global macro-economic events. Of these, the last two factors have come to play a disproportionately larger role after Lehman collapse pushed the world into recession.

The theory of “emerging market de-coupling”, which was propounded in the West in the runup to the crisis, has lost credibility and India remains closely hinged to events in the developed world.

Since the last time the rupee touched the 68.80 level to the dollar in September 2013, India’s macro-economic indicators have shown considerable improvement. Fiscal deficit has come down from 4.8 per cent to 3.9 per cent of GDP. CAD has fallen sharply from 4.2 per cent of GDP to a shade over 1 per cent, with realistic chances of the oil price collapse bringing about a surplus on the current account in FY2015-16.

Moreover, wholesale price inflation, which was hovering at around 10 per cent, is now in the negative territory for the last six months! One cannot then, solely on the basis of economic fundamentals, chart about an explanation behind the rupee’s current fall from 58-59 to the dollar to 68-69 levels (a 17 per cent fall) in a matter of 18 months. There is something more at play here.

PIMCO’s former CEO Mohammed Erian in his new book Central banking: The only game in town, highlights how a deluge of central bank debt purchases has heralded an unprecedented era of frothy asset prices and introduced systemic risks. While this has happened because the political establishment has largely skirted responsibility, near-zero interest rates have led to competitive currency devaluation in the developed and emerging markets alike, and led to profoundly volatile exchange markets.

With China showing definitive signs of slowdown, the risk-off mode of global portfolio investors has already seen trillions of dollars exitting emerging economies (EM). While India has managed to better most of its emerging market peers, doubts linger about the government’s ability to tread on the path of fiscal prudence.

Financial markets are manifestation of the rule that asset prices can remain detached from underlying economic fundamentals for long periods. The principle of ‘reversion-to-mean’ has been statistically discredited. Highly integrated financial markets and overarching actions of central banks have only made protecting business margins and reducing balance sheet volatility more challenging.

The period of rupee stability (and strength) we witnessed after the BJP government assumed power at the Centre has not lasted beyond the first 12 months. Just as in 2013, the dollar-rupee volatility was characterised by ‘taper tantrums’ in the US, the rupee weakness since June 2015 has been largely triggered by the response of foreign portfolio investors to the US Fed’s decision to hike interest rates. RBI, meanwhile, has intermittently sold dollars in the spot and forward markets to curb sharp rupee weakness.

Notwithstanding the fiscal relief the fall in oil prices has brought about, concerns about China’s growth continue to cast a shadow on all emerging market economies. With a backdrop of these developments, we feel that rupee’s fate in the short to medium term will continue to be guided by global marco-events and central banks’ policies rather than economic fundamentals alone.

It is, therefore, imperative for treasurers the world over to construct an all-weather risk management framework, which is not only capable of responding to fickle markets but is also able to provide operational flexibility in the face of evolving regulations and market structure.

As John Keynes said, “Markets can remain irrational far longer than you can remain solvent.”

Rajarshi Guha, Senior Consultant – Advisory Services has also contributed to the article.

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