We know that RBI has been intervening in spot and forwards markets. From September 2013, when governor Raghuram Rajan took charge, till August 2014, RBI had accumulated $32.5 billion in the spot currency net purchases (RBI’s foreign currency assets have increased by $31.7 billion since September 2013 to October 24, but these are our estimates; details of valuation changes in the component currencies are not available). In the forwards segment, the position has reversed from net shorts of $32.5 billion to net longs of almost $8.4 billion by September-end, which is likely to have increased even further by October-end. This will have covered the entire redemption of the bank MTN swaps of $8 billion due in October and November. Thereafter, the net long forwards position will have to be gradually built up over the next two years to cover maturing of the $26 billion FCNR swaps outstanding, due to mature by November 2016.
Understanding RBI actions is important as a guide to what might lie ahead for the rupee. In an environment where developed markets are attempting to manage their currencies through various quantitative easing programmes, the past balance sheet expansions of central banks are beginning to shrink with redemption of papers, uncertainty regarding growth, inflation and the future actions of central banks persists, funds flows to various geographies have become uncertain, and the behaviour of the rupee over the past couple of months deserves attention.
Not only has the rupee maintained its level against the dollar compared to many of our emerging market peers since September (chart 1), it has been remarkably stable as well (chart 2).
The second observation is that while the rupee has depreciated against the dollar, the 36-country Nominal Effective Exchange Rate (NEER) has remained stable over the past couple of months and is now actually stronger than in July 2014, when the rupee had appreciated to 59.75 to the dollar (chart 3). The NEER is a currency index which averages movement against a basket of currencies (36 in this case) of major trade partners. The divergence of the NEER from the dollar-rupee pair is the result of the dollar strengthening against other currency majors. The immediate implication is that while India remains more or less export competitive in its dollar trade, it might be losing its advantage in trade based on the wider basket of currencies. The macroeconomic implications of the stronger NEER might already have begun to become visible, with the September trade deficit up at $14 billion.
From chart 3, one potential inference is that there has been some evidence of the management of the rupee, but with reference to the NEER and less to the dollar. Although RBI has stated officially that currency management is used to “limit volatility”, it appears as if an NEER band is being enforced. This support had been stronger in the past, but seems to have moderated over the last couple of months, probably due to the quantum of movement of the other major currencies versus the dollar. Given the weight of the other currency majors in the NEER, in the absence of such intervention, we surmise that the NEER would actually have appreciated, rather than remain in the narrow band. This hypothesis of support for the NEER instead of only the dollar is consistent with RBI appearing to buy (buy, not sell) dollar at the 61.20-61.30 levels.
What might motivate managing the directionality of the currency rather than strictly its volatility? As with all currencies, there is now an important monetary policy component embedded in the rupee, balancing the compulsions of export competitiveness and imported inflation (Singapore targets the NEER rather than interest rates as its monetary policy instrument, but that is predicated on its relatively small size and openness to trade and capital flows). In addition, and this is a more convincing argument, market perceptions of a predictable range for the rupee might encourage carry, with funds arbitraging higher interest rates, and of greater concern, running unhedged interest rate positions.
As to the choice of target, it might make more sense to target the NEER rather than the inflation adjusted counterpart (REER), given the immediacy of the instrument, rather than one which is available with lags of at least a month. Of course, targeting a broader basket instead of a specific one also offers the flexibility of exploiting market momentum, and might result in better utilisation of forex reserves to achieve the desired objectives. Stability in a wider currency basket probably also moderates hot money volatility, thereby potentially keeping near-term interest rates in line with the monetary policy stance.
This has implications going forward. If the dollar-rupee spot and the NEER divergence is here to stay, as weakness in the eurozone and other emerging market currencies suggest, there might be further continued RBI dollar-buying at higher levels. This is then likely to sustain the depreciating bias of the currency. There are other economic reasons for this view as well, which we will explore in a separate article.
By Saugata Bhattacharya
The author is senior vice-president & chief economist, Axis Bank.
Views are personal
(Tanay Dalal contributed to this article)