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Riding the Rupee Tiger

I wrote this for Pragati in October 2013

The arrival of a new RBI governor seems to have clicked with the markets – stocks are up to near-all-time-highs, while bond markets have remained positive after some scary moves. The Rupee has reversed rapidly, down to the Rs 61 levels from the Rs 68 they had briefly touched. But this is the first reaction to a ‘steroid’ in the form of short-term measures designed to lift the rupee up.

Much of the rupee move has come because:

One, Gold imports have slowed due to the extreme import duty that has now been applied, and RBI restrictions.

Two, The RBI has continued to sell dollars in the market, and foreign investors have brought in an enormous amount of money via equity.

Three, The oil marketing companies buy dollars directly from the RBI, through “OMC Swaps” that were designed as a short-term measure.

The problem? These issues are great stop-gap measures, designed to cull panic. While they have succeeded, we cannot exit from these policies easily.

The Gold import duty introduces a problem we have seen to our extreme discomfort before the 90s: smuggling. The coast was rife with ‘dons’ bringing in gold undeclared because the regular channels did not allow them. Some of them are now funding terror on Indian soil, colluding with rogue elements in neighbouring countries. We don’t want that again, and the only way out is to curb gold smuggling before it becomes too big. Gold is easy to smuggle – it’s very valuable in small sizes, and eventually fake companies will be set up to ‘import’ things which cannot be measured, like software, so that the dollars – used to pay for the gold – can be taken out legally. The only real way to stop smuggling is to bring back to duty to a more reasonable number, like 1 percent.

RBI restrictions on gold include who can be funded, for how long, and what they can do with it. This kind of micromanagement is frowned upon in large economies, and there has to be a reversal because such rules only prevent the price of gold from being discovered in India. All it has done is create a shortage of physical gold, as demand exists but jewellers can’t easily import gold.

But an exit will mean gold imports will resume, and take the rupee down again. While we live on the short-term ‘steroid’ of high duty and funding restrictions, the inevitable reversal of these measures will show us we only attacked the symptom, not the ailment.

Foreign investors have bought in large quantities in September, with their total investments at $1.2 billion for the month (debt + equity). However, this has already tapered off in October – despite R. 10,000 cr ($1.6 billion) of investment in the equity market, FIIs have sold Rs 10,000 cr of debt making October “flat”. FIIs have, in fact, sold debt for five consecutive months.

RBI’s selling of dollars to buy rupees has kept the rupee under control, but this selling is bound to stop as the central bank gets spooked when reserves fall beyond a certain level. Foreign investors won’t keep coming forever – especially not if the US Fed decides to ‘taper’. The reversal of foreign flows can easily take the rupee back to its lows, especially as other measures are unwound.

The OMC swap is especially dangerous. Indian oil marketing companies buy $10 billion worth of oil every month, and this buying of dollars would hit the markets. And that would put pressure on the rupee, sometimes in a sudden move. The RBI – even before Rajan took over – put in place a measure where OMCs could buy dollars directly from the RBI  and return those dollars at a later date after buying it from the market instead.

This exposes the RBI to the creditworthiness of the Oil Marketing Companies, which, to be honest, are not very creditworthy. They are very high debt companies, with bureaucratic functioning, and entirely dependent on government subsidies for their profitability. And then, what if they try to return those dollars and their attempts to buy from the market take the rupee down in a big way?

The mere rumour that the RBI might stop this ‘swap’ to OMCs took the rupee down 2 percent and the RBI had to issue a clarification that no, we will continue administering the steroid, before markets levelled off.

There’s one more measure: the FCNR Swap. RBI allowed banks to get Foreign Currency Deposits, and give those dollars to the RBI (instead of selling them in the market). In exchange they had to pay just 3.5 percent on the rupees received, for three years, after which they would get back the dollars. The idea is to reduce the hedging cost (of dollar-rupee) to 3.5 percent per year, when markets were pricing it at 6 percent per annum.

This has brought in over $10 billion in the 45 days since the announcement. Yet, this $10 billion will not directly impact the forex market for the rupee. Since the dollars are being sold directly to the RBI, at a rate that that the market has already determined, the avalanche of dollars is not hitting the market directly which would have taken the rupee up (and the dollar down). The only impact there is that the RBI can take those dollars and sell them in the market by itself – but then it already has over $250 billion, which dwarf’s the $10 billion this measure has brought in, and therefore this measure, for the USD-INR equation, is just optics.

The best mechanism to control the rupee-dollar equation is to have our exports trump imports. The gap is so wide today that it seems the rupee must fall much more so that our exports are competitive – even in the last three months, the trade gap hasn’t gone down substantially. Another method is to make our currency and markets more open, allowing the currency to be ‘free’ (even if it means a far higher exchange rate) – the markets will find their equilibrium. Both these measures will take a long time – much longer than we have to must reverse our shorter term tactics.

The bigger problem is, now that we seem to have brought the rupee under control, the unwinding of the measures that were designed to be short-term. This is a not just specific to India – even the mention of the US Fed slowing its purchases of US Government Debt, not actually doing it but saying they might have to, took their bond and equity markets down in  a big way.

Riding a tiger can be a lot of fun, but if you get off, the tiger will kill you. The question is – have we tamed the animal that is the rupee-dollar exchange rate, or are we going to find ourselves back in very dangerous territory?

  • charles says:

    The market is already rumbling trying to price in potential impact of some of the stuff ur saying. I believe a taper now will hit the rupee doubly hard. Even in the absence of taper the net fii flows are flat . The fcnr n omc swaps are timebound even if gold imports can be disguised as smuggling. The moment fcnr goes expect 70…when omc goes expect 80 and.if taper happens expect 100. Ur absolutely right that till exports resonably match imports nothing is sustainable

  • KS says:

    ” the US Fed slowing its purchases of US Government Debt, not actually doing it but saying they might have to, took their bond and equity markets down in a big way.” is that means FED is in control of the market, I don’t think so, because history shows the market crashes even before FED existed. You mentioned in some other articles that big crash will come with big retail investor participation. That is not happening now. Right now europe in big mess. So, there will be capital moving into equities as withdraws in debt.
    What is your thought about funds removing from Debt market?

  • Leo says:

    one way to kill dollor unwind do a volcker…….KILL the equity bulls and raise will be painfull but it will bring in long term money
    Had they done it when INR was 50 it would have been less painfull…but now US fed has lost control of rates *which people dont believe in.and rates are about to explode 500 bps
    RAJAN MMS CHIDDU cant rig anymore ..>GAME SET MATCH …expect all banks tanking all real estate tanking once GSEC crosses 9%—- finally the speculators will be crucified on the wall for everyone to see
    The best thing to do is take the pain now or the mkt will do it for you.It is never late.
    We have trillions unwinding when US rates few FCNR billion are drops in a bucket

  • IsItPossible says:

    Lets take a BIG picture perspective:
    As of now TWO major scenarios exist –
    1. A severe market crash, much worse than 2008 (will happen over next 2-3 years)
    2. A massive BULL market start similar to one we saw in 2003 (will provide confirmation during next 6-8 months)
    This is based on chart analysis of Dow going back to 1970’s and we shall see early signs in next 6 months. Even if NIFTY makes a all time NEW high, it will need atleast 6-8 months to form a nice base and in all probability will come back to test the support. In either case, it feels like smart money is in staging area and hence the market is kept in a wide range for now. Until election results are out, this market is NOT going to make any major moves.
    Regarding rupee, we shall see it move towards 70-75 range as underlying policies are NOT long term, besides next election outcome is very volatile, which means we might have 180 deg shift….
    ONLY time will tell…. 🙂

  • abcxyz says:

    “The gap is so wide today that it seems the rupee must fall much more so that our exports are competitive”
    Nope I disagree. Low rupee is not the only criteria for increasing export.
    To make export-oriented goods we need to must have
    1. Low barriers of investment – read good policy and regulation
    2. Low political interference – read low crony capitalism
    3. Good Infrastructure – read good roads and railways
    4. Reliable access to inputs – read reliable electricity, water etc
    5. Reliable Manpower – read low union-baaji, low political interference.
    If we don’t have the above 5, no amount of currency devaluation will help in the long term.