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Rupee Fall: The Tightrope Walk Between Policy Options And Consequences

BloombergQuintOpinion

You’ve heard many analysts say that the rupee fall of 2018 is different from 2013. They are right. Every period in the markets is different from the next.

In 2013, the fall in emerging market currencies stemmed from a mere mention of unwinding of the U.S. Federal Reserve’s quantitative easing program. This was not even a formal monetary policy announcement but just the hint of a change in policy was enough to spark a sell-off in emerging market currencies.

Economies tagged as the ‘Fragile Five’—those with high twin deficits and inflation—were worst hit. The experience of that period forced emerging markets, including India, to repair some of those cracks. Over time, normalcy was restored.

The prevailing situation today is quite different.

Yes, India is in better shape now. The fiscal deficit has been decisively brought down to 3.5 percent from 4.8 percent of GDP. Remarkable improvement has also been made in addressing inflation. Average retail inflation has halved to 4.5 percent as compared to near 10 percent in 2013. The current account deficit is likely to be close to 2.6 percent in FY19, as per India Ratings’ expectations, compared to 4.7 percent in FY13.

While these are necessary factors to tide over any global currency carnage, they may not prove to be sufficient.

Firstly, we are now in the midst of real unwinding of unconventional monetary policy. The Federal Reserve is hiking rates and there is talk that the pace of balance sheet unwinding could accelerate. A strong U.S. economy could call for greater pressure on interest rates and lead to a stronger dollar.

Second, there are tariff wars underway, adding more fuel to the U.S. dollar. Together this is hurting sentiment towards emerging markets.

Options And Implications

For now, both the government and the RBI have not communicated any discomfort with the pace of the rupee depreciation. But should the country need to stem the fall, what are the options?

  • Should we allow more flows through capital market?
  • Or, just like in 2013, should we look at a one time measures to attract fund flows?
  • Or, should linking of domestic bonds to global bond indices be pursued as a structural solution?

Lets start with the last option.

The current situation raises a question over the efficacy of linking domestic bonds to global indices. Take the example of Indonesia, where 40 percent of sovereign debt is held by foreign investors.

Indonesia has been forced to hike its policy rate by 100 basis points in 2018 not because of its inflation and growth trajectory, but to safeguard against external turbulence.

Seeing what’s happening across economies like Indonesia, suggests that the RBI’s cautious approach on allowing foreign participation (especially in the bond markets) is justified. The stance appears to have been carefully crafted to balance monetary policy independence against the backdrop of the impossible trinity.

Another option is to try and attract foreign fund flows over a short period by creating an incentive structure through a specific instrument or arrangement. This mechanism has worked well at various times in various forms – the most recent being the concessional Foreign Currency Non-Resident Deposit (FCNR-B) swap window in 2013. The scheme worked well, garnered about $30 billion and helped to rein-in a rapidly weakening rupee.

Although this option has become an effective prescription against bouts of currency weakness, the ‘moral hazard’ attached to such options should never be ignored.

Such schemes are one-off fixes that can be used to buy time while addressing short-term anomalies. However, the repeated use of such measures can influence choices made by global investors and depositors and, in turn, become a self-fulfilling prophecy. Depositors and intermediaries may develop an expectation of such measures and this could add to pressure on a currency in adverse times.

There are other implications of such schemes too.

A recent article authored by RBI staff on forex management, raised a pertinent point. The authors have surmised that with rising dominance of foreign portfolio investors in that domestic capital market (particularly the bond markets), the process of sterilising large foreign inflows becomes challenging and leads to an adverse feedback loop. The RBI sterilises foreign inflows by buying dollars, which, in turn, leads to rupee liquidity being pumped into the domestic markets.

Extending that argument, abrupt foreign inflows following any extraordinary measures could lead to a sudden rise in domestic liquidity. The RBI would then need to stem in to adjust liquidity conditions based on its monetary policy stance and inflation conditions.

If the RBI chooses to sell bonds through open market operations to absorb surplus liquidity, it could lead to an increase in domestic interest rates. Even without OMO sales, a change in expectations on bond purchases under the OMO program could be detrimental for the rates.

In the end, you may attain rupee stability but push up interest rates in turn.

Automatic Stabilisers

The current pressure on currencies like the rupee is driven more by fundamentals and policies. Thus, it may be difficult to stand in the way of the adjustment in the exchange rate except by reducing excessive volatility.

The best option may be to bank on automatic stabilisation mechanisms, which would eventually act as the best defense.

For instance, a strong U.S. dollar is likely to start impacting U.S. growth and eventually lead to a weaker dollar. Moreover, renewed hope from European Union countries is likely to anchor strength to the U.S. dollar.

Similarly, in India, a weaker currency could have some bearing on export growth and may help bring down non-essential imports. This, in turn, would act as a natural stabiliser.

Soumyajit Niyogi is Associate Director at India Ratings & Research - a Fitch Group Company. The views expressed here are his own and do not reflect those of his organisation.

The views expressed here are those of the author’s and do not necessarily represent the views of Bloomberg Quint or its editorial team.