Who let the Rupee fall?

Ajay Mahajan        Print Edition: Jan 22, 2012

The preceding six months of the year 2011 will remain firmly etched in the minds of anyone who is even remotely bothered by the value of the rupee. And who is not - exporters, importers, businesses, government, bankers, even individuals, especially those travelling overseas who find themselves paying 20 per cent more for the same number of dollars they got in July.

So what happened? What went so horribly wrong with the Indian exchange rate in the last six months - something that most experts in the business could not predict? Let us face it - many emerge now saying I told you so!  Wonder if they were really there when the rupee remained adamantly constant between 44 and 46 against the US dollar, and there was an attractive 25 paisa a month to capture as "carry" or "reward" for holding a short dollar position every month!

In our assessment, there is nothing wrong with trying to extract "carry" out of a stable market environment. Where most go wrong is when they decide to keep their entire exposure open in order to maximize from continuity in "current" market behavior. That market behavior does not remain the same is easily forgotten -  else predicting markets would be simple and so would be making money from positioning.

The Indian currency began to lose sharply triggered by events overseas.  Euro zone worries began to mount, as it became almost certain that Greece would default, the concerns spreading to several other euro zone countries - Italy, Spain, Portugal and Ireland. Credit ratings of several countries were downgraded by major rating agencies. Us Dollar began to harden as a "safe haven" currencies do at such times of uncertainty.

Risky assets came under pressure as the ongoing euro zone concerns stayed centre stage, despite huge political action in Europe to salvage the much questioned "single currency".  Closer home, India's macroeconomic woes grabbed global headlines in respect of its high inflation, large fiscal deficit and growing negative current account balances. The banking sector lost its shine driven by expectations of a growing volume of non-performing assets and massive rate hikes leading to surging cost of funds.

Large positioning started to load against the rupee as it became an "easy" trade for hedge funds which hadn't seen a spectacular year in 2011 anyways. Nor did the Reserve Bank of India's statements help the rupee's cause. For tenuous markets, "perception is reality". Even if the options before the central bank were limited, an open admission of the same corroborated the speculator's view. USD 300 billion of reserves are not large enough to intervene in large amounts very day, however, it is a precious source of strength for volatile times and should be used efficiently to arrest highly speculative declines in the value of the currency.

At times like this when panic grips, even stable emerging economies have to face the brunt of repatriation of foreign capital. The more exposed a country is to "hot inflows", the more the risk of overextension of currency  weakness in difficult times.  It may be worthwhile remembering that earlier in 2011, a major debate had erupted on whether India should impose a tax on offshore investors bringing large inflows into India for investments in  financial markets and businesses. Six months later, we see a highly concerned government and the central bank taking measures to improve inflows. In short, does anyone know what the future has in store?  If learned and highly skilled hands do not know the future of their own currency, why should any business or any company or individual risk its financials by taking large, unilateral bets on the currency or any other market variable?

After a sharp fall this quarter, the central bank has taken very specific steps to curb volatility in the currency markets. It may be worth noting that the volume of Indian currency traded offshore is higher than the volume traded onshore. While banks face a lot of restrictions in what markets they can operate in,  some entities are able to exploit arbitrage between onshore and offshore rupee levels thereby making it difficult for the central bank to contain volatility from seeping into the onshore markets.  The measures announced recently have managed to arrest some of this arbitrage and helped slow the pace of decline.  NRE rates have been freed finally! In our view, that should have never been disincentivized so badly. Non-resident external rates were a good 600 basis points below the market without any ostensible reason.  This correction should certainly improve inflows.  

One point begs attention. If increasing market volatility thanks to increasing globalisation is a reality, regulators will need to be very balanced while framing rules and regulations. Longer term flows segments like foreign direct investors, non-resident Indians and equity investors need to be developed proactively and addressed with the same level of consistency, no matter whether rupee is favoured or disfavoured at any specific point of time. Else, rules may need to change every six months to suit the country's requirements which will exacerbate short term stresses.

If the overall risk sentiment in the world improves, we could see rupee outperform other Asian currencies after the large battering it received recently, but the chances remain slim. The scales are still heavily tilted towards further weakness as the euro zone will continue to induce fears. The slowing world economy does not bode too well for growth and elevated oil prices do not look likely to fall.

And in the midst of all this mayhem, what should corporate houses do? We would advise the following - 2012 appears to be a tough year ahead. Market volatility is likely to be high. Rather than maximize from a directional view of rupee weakening or strengthening, the 'Net Open' position a corporate has at any point of time needs to be reduced and managed very delicately by trusted hands.

The author is Managing Director, FICC Capital

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