Opinion Talk is cheap

the difference?

Several fundamental explanations — count them,six — have been offered for the rupee’s slide. First,the rupee is reflecting “market fundamentals” and is finding its “free market” level; so let it be. If it depreciates,that is normal. If it appreciates,it is natural. Now,most reformers do believe in giving a lot more importance to market forces than the vicissitudes and idiosyncrasies of politicians and bureaucrats. Count me as a card-carrying member of that near extinct tribe in Nehruvian-Gandhian socialist India. But prudence dictates that we do not get carried away by the myths of our own making. No country allows the exchange rate to freely operate,not even the reserve currency,the US,nor that most capitalist free market country,Switzerland. So,at a minimum,let’s get real,and rational.

The second fundamental offering is that the FIIs have been withdrawing money from Indian capital markets. (Recall that the rupee was at 45.8 on August 31,2011,a good 15 per cent away from its closing low of 52.50 a few days ago). According to SEBI data,there has been a net $3.6 billion inflow in 2011 (until November 24). Equity inflows have been small,but the exchange rate is not determined by equity inflows alone. And in October 2011,the month of more than $ 600 million inflows (equity and debt

$ 330 and $270 million,respectively),the rupee depreciated by more than 3 per cent.

Third explanation: it is the euro. Europe has been stuck in a quagmire of its own making,and the news flowing out of the eurozone does not spark confidence in any soul,excluding the Germans. But even Germany cannot sell its bonds any more. Given all these negative factors,the euro is almost exactly the same level as it was on December 31,2010 — 1.34 to the dollar. So the euro doesn’t explain it.

Several other “fundamental” reasons abound. My favourite (besides the FII figures noted above) is that we had a $20 billion trade deficit in September (fourth explanation). This is what caused the rupee’s rout! But until yesterday,we were told about the great Indian success story of 2011. Exports exploding and imports imploding. One-month data does not determine the value of a currency,the last time I looked. For the seven months of April-October,the trade deficit in 2010 was $92 billion versus a deficit of $72 billion last year. So let us see,a $20 billion increase in the trade deficit causes a 17 per cent depreciation of the rupee. And a $600 million monthly inflow of dollars causes the rupee to depreciate by 3 per cent. Simple conclusion — no matter what,the rupee depreciates. Why do we need economists,or policy makers,or traders,or markets?

Fifth explanation: the RBI’s relentless hiking of the repo rate. While interest rates in some developing countries have declined,and in many others a pause in hikes has been struck,the RBI increased the repo rate by 25 basis points in late October. For the year,this was the seventh increase,for a total of 225 basis points. Interest rate hikes are supposed to help,no? Actually not — they hurt; currency markets react much more to growth differentials than interest rate differentials. Accompanying the interest rate increases — an uninterrupted decline in the value of the rupee. The more extreme and fundamentally unwarranted the repo hike,the worse was the rupee’s slide.

Sixth explanation: the real exchange rate had appreciated beyond a tolerance level. Of all the reasons offered above,this one is the real McCoy. But the chart suggests otherwise. The RBI publishes a comprehensive 36 trade weighted country real exchange rate series. The data for October and November are approximations. For the entire near twenty-year period of 1993-2011,this is only the second time that the rupee has been so cheap. Excluding 2008-9,unambiguously the cheapest ever,even cheaper than during the East Asian crisis years. And if the approximations are too conservative,then the rupee at 52.50 may have been at its lowest,ever!

Conclusion: there is precious little fundamental reason for the rupee to depreciate as it has done in 2011,and even less reason for it to depreciate at the speed of a Ferrari. If there are no fundamental reasons,what gives? Sentiment and expectations. The Centre has done everything possible to sour expectations and sentiment with regard to India. This has hurt. If this were not enough,the RBI messed up,by talking too much and stating that the rupee was a free floating currency. The market tested that ridiculous assertion. The market won. The RBI had to backtrack. Central bankers should be seen more,heard less. The rupee slide was aided and abetted by mismanagement of the interest rate and exchange rate policy. There is ample reason to believe that RBI is not independent,and that a considerable portion of mismanagement might actually be attributable to the Centre. Whatever the real cause,India is the loser.

Maybe a loser in the past sense. Markets have a tendency to overreact,and even policy-makers learn from past mistakes. The rupee at historical low levels is not sustainable,nor are interest rates at such levels credible. Even before inflation falls (likely soon?),the fundamentals suggest a reduction in repo rates,and an appreciation of the rupee. The future is much less bleak than the past.

The writer is chairman of Oxus Investments,an emerging market advisory firm