Don’t defend the rupee: Financial Express: 22nd May 2012

When the rupee is volatile and there seems to be no sign of light at the end of the proverbial tunnel, it makes a lot of sense to let things be as they are. RBI has limited ammunition to defend the rupee and any kind of sale of dollars gets absorbed soon and the situation reverts to the status quo. And the pockets are not deep. The rupee is being driven by fundamentals as well as extraneous conditions. Within fundamentals there are two sections. The first is the current account deficit, which is under pressure, being close to 4% of GDP—though the exact number prevailing in May is unknown. But we do know that exports could be slowing down while imports are stable largely due to declining gold imports and lower oil prices. Invisibles could be marginally better, and hence the deficit could at best be stable. Looking at the capital account, there are four elements that can change the face. FDI has been buoyant last year, and will be steady. FIIs are still suspicious and there are outflows rather than inflows. NRI deposits are largely steady and inelastic and RBI has allowed for better returns to induce more flows. ECBs are useful, and RBI has been liberal here. But, companies will not be borrowing now as this is the non-peak season. Also, there is little investment taking place, and given the state of euro markets as well as India’s own state of economy, the rates may not be too fine in case one adds the cost of rupee depreciation to the credit risk premium. Here, evidently, RBI cannot make a difference through intervention. The extraneous condition is the dollar-euro relationship. When the Greek debt was swapped, it was felt that a solution was found. But, there are good chances that Greece will renege on its side of the deal of following austerity. The dollar will hence continue to strengthen as long as the euro region is fragile. Greece will remain in suspension till the June elections, and if it goes down and out of the euro, contagion will spread to Spain, Portugal and maybe even Italy. All this means the dollar will become stronger and the rupee will take a beating again. Will RBI intervention work here? The answer again is no. Either which way, RBI cannot really combat such adversity and it makes sense to let things be. Will this be the end for us? The answer is no. While the panic is palpable currently with cries for intervention, there is an obvious solution that has been missed here. All the affected parties should be using the F&O route and hedge their risks. The forex derivative market is well developed and surprisingly all through the crises months last year as well as this year, the overall traded volumes have remained largely stable and not increased. Why aren’t corporates hedging? Our imports could be $600 billion this year, which should ideally be hedged. Hedging is insurance for price risk, and the price here is the exchange rate. Simply put, when we see the rupee depreciate, one should go long and buy forward, so that when it does depreciate, there is cover. Similarly we have debt servicing to be honoured during the year, which should be hedged. And since there are ‘options’ available now on the forex currency exchanges, the actual cost is only the option premium. Corporates are already in the habit of hedging their raw material risks either through global futures in case of crude (NYMEX or ICE) and metals (LME) or through bilateral agreements with vendors domestically. Forex is one commodity that is generally not touched on the premise that the rupee will never really go very down and that the central bank is there to lend a helping hand. It did do so last year by pushing in over $20 billion to stabilise the rupee. This won’t happen again. The issue is that once players know that RBI will intervene, the speculative elements come in and start guessing the moves. While RBI has put curbs on exporters by ensuring that dollars in the EEFC accounts come in, importers could rush in to buy dollars or plain speculators could start punting in the market. This makes the system even more volatile and unstable as one cannot separate these elements. Markets always self-correct in the absence of intervention as more expensive dollars make imports dearer and exports competitive, which should help in bringing equilibrium. Inflation will certainly be there, but then we cannot expect some authority to intervene for each element of inflation when there are demand-supply mismatches. For the theoretically inclined, even the REER (real effective exchange rate) is at a low, which should get reflected in the nominal rate (which it does). We should certainly not hold on to an unrealistic rate merely because we are used to a dollar coming for less than a certain targeted rate.