How important is the Fed for the rupee?

By: |
August 23, 2021 6:15 AM

Taper II could see modest outflow of portfolio debt investments, but the amount is unlikely to materially shift the balance

More and more analysts forecast this to happen towards the end-2021.More and more analysts forecast this to happen towards the end-2021.

The week ending July 30 saw a huge—$8.6 bn—surge in India’s FX reserves; indeed, 2021 has seen a sizable ($35.6 bn) rise in the reserves till July. Traditionally, when reserves went up, it was driven by portfolio investment, but this is no longer the reality.

Clearly, FPI was a minor source—just 10% of the total accretion—with FDI (largely into unicorns) and fresh ECB drawdowns being the major players. FPI investment in debt, which would, in theory at least, be most sensitive to the US Fed, was modestly negative during this period, perhaps in expectation of Taper II.

So, what will happen when the Fed does begin Taper II?

More and more analysts forecast this to happen towards the end-2021. Inflation remains a growing concern. Despite the fact that the US yield curve has flattened—the 10-year/2-year spread has come down from 1.60% in March to around 1.05% today—steel and other raw materials are raging with no cooling in sight; shipping costs remain very high with supply still badly constrained. And while the Delta variant may yet derail—or, more likely, wobble—the US economy, it generally appears to be on track for a very good year.

US president Joe Biden’s spending plan, which looks set to pass through Congress, although he will have to face some political fallout from the tragedy in Afghanistan, will certainly add to inflationary pressure. To be sure, there are credible voices saying government spending, if based on investment, is not necessarily inflationary; but it appears that the market has accepted the fact that inflation will rise. Indeed, my sense is that markets are awaiting Taper II and likely would be concerned that the Fed is falling behind the curve if it were delayed beyond the end of the year, in which case we could see equities fall out of be.

Incidentally, this anxious wait for Fed action highlights how regulators have become the handmaidens of the trading community, contributing in no small measure to the huge—and rising—inequality in the world. Traditionally, “the central bank was like God; you know she was there, but you never heard or sighted her till there was a crisis.” Banks and other traders—there were no arbitrageurs—took positions very carefully based on their capital and risk appetites. Trading volumes were lower, as were profits and bonuses. Today, the Fed keeps on talking, broadcasting what it is going to do and when, enabling “smart” traders to take positions to maximise their returns. It is not regulation, it is subsidy to those already vested in the market.

Coming back to the arithmetic above, the impact of Taper II, or even rising US rates, will be much more subdued than the last time around (when the reserves fell by 7% in a few months). This is because the lion’s share of the rise in reserves, and, hence, rupee strength, are FDI and fresh ECBs. While ECBs could be marginally affected by rising US rates, the FDI tap looks frothingly full, with FOMO infecting more and more private investors. Sure, we could see modest outflow of portfolio debt investments, but the amount is unlikely to materially shift the balance. In any event, RBI would simply have to buy fewer dollars to maintain rupee status quo. Of course, volatility will increase, but I don’t think it would be sufficient to push the rupee out of the 80-90 paise range we have been witnessing for the past couple of months.

If, however, the Fed does not perform as its master, the market, expects it to, and there is a sudden equity collapse, there could be a shift in sentiment. Then, depending on how long the nervousness sustains—and any number of geopolitical forces could exacerbate things at the time—we could see an increase in outflows and a reduction in fresh ECBs. My sense is that the unicorn show will, however, continue, so that, even in these more difficult circumstances, the rupee may be hard pressed to break its all-time low of 76.50.

The author is CEO, Mecklai Finance
www.mecklai.com

Get live Stock Prices from BSE, NSE, US Market and latest NAV, portfolio of Mutual Funds, Check out latest IPO News, Best Performing IPOs, calculate your tax by Income Tax Calculator, know market’s Top Gainers, Top Losers & Best Equity Funds. Like us on Facebook and follow us on Twitter.

Financial Express is now on Telegram. Click here to join our channel and stay updated with the latest Biz news and updates.

Next Stories
1Auto PLI adds force to the EV wave
2Not a time for booster doses
3Auto PLI’s EV focus is what India needs