Communication by the apex bank can have positive ramifications for rupee movement

The free fall in rupee value recently has overtly surprised most of the analysts (I am no exception). In fact, there was no inkling of this sudden and precipitous fall in the rupee value till the last week of May. Interestingly, the rupee had stayed remarkably benign in 2013 (refer graph 1 for volatility measure in 2013), till it lost close to 5% against the dollar in a span of 14 trading sessions (May 22-June 10, 2013). The rupee has not been witness to such sudden and heightened volatility even in 2011 when the currency, at the peak of its crisis, had lost 8% of its value against the dollar, but that too over 46 trading sessions (refer graph 2 for volatility during January 2011-March 12)! Is this panic reaction justified by economic fundamentals, or otherwise, and most importantly is there a way forward?

To begin with, current macro fundamentals did not warrant such a steep fall in rupee fall in the first instance. Capital flows was buoyant (portfolio inflows in 2013 had been close to $20 billion till May 24, 2013) and six country REER was closer to par value of 100. Additionally, turnover in the foreign exchange market indicated declining excess demand in the merchant segment and excess supply in the interbank segment (excess demand for dollars in the merchant segment of the forward market that crossed $14 billion in January 2013 has declined to $988 million in April 2013). There was also an excess supply in interbank market. Also, global commodity prices were at record lows (and till today). All in all, the rupee outlook remained positive amidst expectations of a continued buoyancy in capital flows, benign domestic inflation trajectory and declining global commodity prices.

However, the immediate provocation for the free fall was perhaps an innocuous statement by Fed indicating that even though it would continue to purchase assets mortgage backed at a pace of $85 billion per month, it is prepared to increase or decrease the pace of such creation, depending upon the inflation outlook and labour market conditions. The market immediately lapped up the statement as a possible suggestion of scaling down of asset purchase programme, and Indian market was no exception. For the record, the depreciation in Indian currency by 5% was more or less in line with Brazilian Real (at 5%) and South African rand (at 6%) post the Fed statement on May 22, 2013. In fact, if we compare the movements in rupee value since the rating downgrade of the US economy, the rupee has depreciated by 30% (rand by 46% and Real by 36%), and only the Russian rouble has done better at 15% depreciation (with respect to BRICS group of economies).

Before we move on to the possible way forward, let us mention the two most significant impacts of the rupee depreciation. First, the most significant negative impact of rupee depreciation could be on the current account deficit (CAD). At any point of time, movements in CAD could be attributable to price impact/exchange rate movements and quantity impact. Our estimates suggest that 1% rupee depreciation leads to a 5 basis points deterioration in CAD as a percentage of GDP. Second, depreciation in the rupee may impact imported inflation which consequently will increase overall inflation. However, there is a catch here. Depreciation in the value of the rupee may not always push up the imported inflation, in a situation where corporates have weak pricing power. As an example, there has been episodes in the past when even though rupee has revealed a depreciating trend, imported inflation has actually declined (during later part of last fiscal).

Now, how to fight such unanticipated volatility? We believe that in Indian context, the signalling channel (Kaminsky & Lewis, 1996) may perhaps be the most potent tool to direct exchange rate movements. The signalling channel in our context indicates that, through explicit press statements, the central bank may alter the expectations about the future dynamics of the nominal rupee/dollar. There have been clear indications in the past that this has worked. In fact, international experience suggest that communication by the apex bank could have important positive ramifications for financial market asset prices. For example, a European Central Bank study (April 2011) suggest that such communications has two important aspects. First, such could either ?create news? by making the asset prices move in the desired direction and or to ?reduce noise?, by reducing the market volatility.

In particular, we specifically examined the impact of all possible statements by RBI, GOI/Fed etc that could have influenced rupee movements (during May 2013-June 10, 2013). Statements were, in turn, categorised into favourable news and not-so-favourable news. For instance, news like ?volatility is unwarranted? was construed as a favourable news, whereas news like ?Fed statement on rolling down QE3? were construed as not-so-favourable news. As expected, while favourable news was expected to strengthen the rupee, not-so-favourable news was expected to weaken the rupee. The dependent variable was rupee volatility/depreciation in exchange rate. In terms of the regression results, favourable news indeed had a much stronger impact (generally, the rupee recovered with a lag whenever there was a positive statement) on rupee movements. In concluding the analysis, it is therefore worth mentioning that the news channel may be used as an important signalling mechanism to curb the volatility in the rupee value, whenever the need arises. This study could be extended over a longer time horizon to get even better results. The fact that favourable news has indeed a significant soothing impact on rupee is substantiated by the Fitch rating action, and subsequent strengthening of rupee by as much as 1% in a single day!

To conclude, the decline in rupee value this time was perhaps against the market fundamentals, as capital flows were strong. With the government also hiking the limit on FII investment in G-Secs by $5 billion ($19 billion out of current $25 billion exhausted) and RBI taking additional measures, the movements in rupee value in the past few days may just be a reflection of (ir)rational exuberance! Let?s hope we are rational soon again.

The author is chief economic advisor, State Bank of India. Views are personal