Abheek Barua & Shivom Chakravarti: Some unpleasant forex arithmetic

Last Updated: Mon, Jun 11, 2012 05:21 hrs

A few things need to be kept in mind in gauging the direction of the rupee over the next few months. Let’s start with some simple arithmetic. A back-of-the-envelope calculation based on estimates of outflows on the current account, committed debt repayments and inflows such as external commercial borrowings, NRI deposits, trade credit and foreign direct investment leaves the economy with an average monthly “funding gap” of about $2.5 billion. This has to be filled by portfolio flows both into the debt and equity markets, principally equities. If these don’t materialise or fall short of the $2.5-billion mark, the rupee tends to depreciate. This is, of course, an average gap. In some months the gap could be larger and were it to coincide with a “risk-off” episode in global markets that impinges on portfolio inflows, the pressure on the rupee to depreciate intensifies.

The Reserve Bank of India’s (RBI’s) market intervention strategy and the efficacy of its administrative measures to support the rupee have to be seen from this perspective. In a period when portfolio flows are weak, RBI has to fill this gap by offering dollars from its stock of reserves. The success of “intervention”, thus, depends on what percentage of this $2.5 billion deficit RBI absorbs by supplying dollars.

There are again a couple of things about RBI’s intervention strategy that are becoming clearer as the rupee comes under successive rounds of depreciation pressure. First, RBI is unwilling to do much when there is risk aversion all around. This was quite apparent in the second fortnight of May when emerging market currencies across the board came under heavy selling pressure on the back of concerns relating to Europe. Thus, as a central bank, it seems (quite sensibly) unwilling to test its strength against a sharp rise in global risk aversion.

Second, RBI seems to be quite keen to save the bulk of its reserves for a rainier day. It seems to (at least implicitly) work with a fairly conservative estimate of the fraction of its reserve chest of $290 billion that is actually “available” for intervention. One way to arrive at this is to consider a situation (call it the tail risk situation if you like) in which there are no inflows on the capital account. This is combined with outflows on the current account, debt servicing and a fairly significant pullout of portfolio investments. If we add these up, we get a number that roughly corresponds to the amount of dollars RBI would have to supply to the market to prevent a free fall in the rupee. Subtract this from the current reserve holding and you are left with $10-12 billion of “available” reserves.

What could lead to appreciation of the rupee? Any positive turn in global risk appetite would be perceived as a signal that the $2.5 billion financing gap is likely to shrink or even turn into a surplus. Markets are nimble and they will not wait for the flows to actually materialise before taking the rupee up. Thus, an improvement in sentiment is likely to get quickly priced into the exchange rate. This is exactly the phenomenon that we saw last week

One can think of two kinds of drivers of sentiment in this kind of a market situation. The first type of sentiment driver is a dissipation of what market types would refer to as “event risk”. This could be, say, a positive outcome in the elections in Greece due this week. This would drive rally that is likely to fade away as the market moves on to fret about other things such as the capitalisation needs of Spanish banks

A more enduring rally in financial markets in general and the rupee in particular could come from one of two things. There could be a major policy initiative in the European Union, say, a move towards greater financial integration. An example would be an announcement that deposits in all European banks would be insured by a central European body.

The second would be another round of massive liquidity infusion by either European central bank or the US Fed. The markets have, for a while, been waiting for another programme like the Long-Term Refinance Operation (LTRO) from the European Central Bank or direct sovereign bond purchases. Softer US data has rekindled hopes of a third round of quantitative easing and any confirmation that the US Fed is considering the idea could turn on a spigot of fund flows to emerging markets.

The flip side, of course, is that if the markets are disappointed with the flow of news on these fronts, it could sell off causing the rupee to depreciate yet again. That said, there a couple of props for the rupee that the forex markets are slowly beginning to price in. First, we are likely to see much softer oil and other commodity prices this year than in the recent past. For a commodity importing economy like India that runs a large current account deficit, this has to be good news. Second, RBI seems more amenable to cutting rates and this could set a bottom to the domestic growth and profit cycle. This could help investor sentiment if only at the margin and prevent a collapse.

The authors are with HDFC Bank. These views are personal

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