RBI must intervene: Financial Express 27th September 2011

The stock market is known for its inherent volatility and, since July 1, has shown annualised volatility of 22% as against 8% in the forex market. In September, however, this difference has narrowed down, with stock market volatility being 26% and forex 12%. Clearly, the forex market has become a more interesting market with various forces at work that have made an otherwise staid market into one which has provoked concern and discussion.

The spot merchant forex market has a turnover of around R3,000 crore a day while the OTC forward registers trades of R5,000 crore. The inter-bank spot and forward markets clock around R15,000 crore each while the F&O turnover on the exchanges is another R70,000 crore. The price discovery process is robust, as the market knows best.

Given the volumes traded and wide-scale participation, there can be no case of manipulation. Therefore, in a free market economy, ideally a sharp depreciation in the currency should be allowed to prevail.

However, if you were the central bank, this stance may not be possible. Theoretically, two sets of factors drive the exchange rate. The first is the physical demand and supply for dollars, and the other is the fallout of the euro-dollar relationship. Both the components are fuzzy today. The demand is not unusual as while the trade deficit has widened, it is still under control. Besides, this cannot affect the rate on a daily basis. On the supply side, the FII flows matter as there is a one-to-one correspondence here. These flows have been fairly erratic on a daily basis, but more stable when aggregated over months.

The euro-dollar relation is more complex. Global uncertainly pervades this relation on a real time basis. The Eurozone is in all kinds of trouble. The rogue nations are on the precipice of default and the trust deficit between nations is at an all-time high. Any news on the default of any nation or the discovery of high debts on their balance sheets is driving the euro down vis-à-vis the dollar, even though nothing much happens on the dollar end. Further, any announcement of a possible stimulus in the US or the absence of one could drive the dollar up or down. In this situation, the rupee takes a hit as part of the transmission mechanism.

A regression analysis of the rupee movement with the euro-dollar movement (with lags) and absolute FII flows on a daily basis since June shows that around 30% of the variation in the rupee-dollar rate since June can be explained by these two factors. The euro-dollar rate, with current and two-day lags, has an influence of around 0.40%, thereby meaning that three days of dollar strengthening by 1% can lead to a 0.4% fall in the rupee. In the month of September, the dollar strengthened by around 5.4% (until September 22), which can explain just over 2% of this variation. The impact of FIIs, on the other hand, is quite marginal at 0.00037 (i.e. $1,000 million net inflows will cause rupee appreciation of 0.37%). The important point is that around 70% of the variation cannot be statistically explained and is attributable to ‘sentiment’. This is why RBI intervention is called for.

RBI’s concern as a regulator is to intervene in any market when there is too much volatility. Bond price volatility is addressed through some large banks while stock prices are addressed by the insurance companies. For the forex market, when sentiment is quite adverse, direct intervention could be justified. The depreciation that we are witnessing has some important implications that can justify intervention if RBI is convinced that it is not being driven by only fundamentals.

First, the boost to exports that depreciation provides is unlikely to materialise since the global markets and world trade have slowed down. Therefore, halting this depreciation will not have an adverse impact.

Second, the chance of imported inflation is there, as imports would continue to flow at a higher cost. Rupee depreciation has already negated the phenomenon of declining global commodity prices. RBI is trying hard to control inflation through repo rate hikes. Letting in imported inflation will be contradictory to its own stance. In fact, imported inflation will not be just through higher cost of imports but also derived inflation where commodity prices are based on a global price discovery process. Third, rupee depreciation will hit our external debt servicing quite hard. This year, there are around $25 billion of outflows, which already mean an additional burden of R10,000 crore for the economy. Fourth, in the first four months of the year, there have been $12.3 billion of ECB approvals compared with $23 billion of inflows last year. A depreciating rupee adds to the future burden. Fifth, companies now wishing to borrow will have to pay a higher risk premium in the euro market.

Under these conditions, there is a strong case for intervention by RBI to control the falling rupee. While India is better placed than other nations in terms of growth, there are still concerns on inflation. Unchecked rupee depreciation, which is not driven by fundamentals, is not a good sign, as it upsets the wobbly apple cart. Sustained intervention with guidance on a target range will help to assuage the market greatly.