The volatility of the rupee has been subdued for some time now, with its long-term average hovering at a 10-year low of around 5%. Governor Rajan has made it clear that he believes keeping volatility low will...
The volatility of the rupee has been subdued for some time now, with its long-term average hovering at a 10-year low of around 5%. Governor Rajan has made it clear that he believes keeping volatility low will help stabilise inflation and he has been acting on this belief. While there is little hard evidence for this belief—inflation in the Eurozone and Japan are extremely low despite average volatilities exceeding 10%—the important question is how much longer can rupee volatility remain so low.
As is well known, volatility is cyclical and the longer it stays low, the closer it gets to a turning point. Historically, whenever rupee volatility fell below 5%, the percentage play was to buy dollars, even factoring in the forward premium; while the rupee did not always fall as much as the premiums, it generally fell enough to make a profitable trade.
With a change of helm at RBI and, importantly, the structural change of monetary policy decisions being taken by the new Committee, it is likely that the iron hand that was needed to keep this natural cycle from expressing itself could weaken, which suggests that, sooner rather than later, rupee volatility will start to rise. And, as always, there are innumerable real world factors that will explain this after the fact.
Currently, the rupee remains underpinned by a steady improvement in consumer sentiment over the past few months—I note the increased thickness of the daily newspapers, the obviously good monsoon and even some glimmers of energy in the till-recently moribund art market. Business sentiment, which naturally lags consumer sentiment, is looking curiously at all this, but corporate investment still seems a way off, as deleveraging continues to be the name of the game. So, too, export growth, which turned negative after flattering to deceive for one month, will keep corporate sentiment circumspect. Exports have declined in 17 of the last 18 months, and while it is not that different for most other competing countries, it would be hard to make a case for stepped up investment in the face of still weak global growth. And finally, while it is great that banks have been compelled to bite the bullet on NPAs, the fact that they are proudly reporting a “decline in the rate of increase of NPAs” suggests this element still has at least a few quarters to go before it can bring its energy into the game.
In all this, inflation is already showing signs of life, with both the CPI and WPI rising sharply last month. And while much of this is related to food inflation, the reality of higher consumer sentiment and muted investment sentiment would shift the supply/demand equation further in the direction of higher prices. Again, the jockeying around GST will certainly increase some prices while reducing others. In this volatile mix, it is hard to see the new MPC jumping to cut rates early, as some are hoping.
The good news, however, is the improving transmission through the bond market which is bringing borrowing rates down for at least the top end borrowers. This could reduce the attractiveness of rupee yields to foreign investors, who, in any case, have not been hot on Indian onshore debt so far this year.
This could be because of the strong, steady growth in global equities. Last week, all three US indices (the Dow, the NASDAQ and the S&P500) hit all-time highs on the same day, the first time that has happened since 1999, right before the dot-com crash. The beyond abundant global liquidity—with the Bank of England the latest to further open the spigot—continues to support equity prices at what many feel are significantly overvalued levels, but we haven’t yet got to the “irrational exuberance” point. It is well known that equities explode higher (or collapse lower) before a major turning point, and, given the general unhealthiness of negative interest rates, there must be an at least even chance that we are on the cusp of a huge equity rally before markets really collapse.
While the dollar has been looking indeterminate buffeted by fluctuating statistics and fears about the global economy, gold is holding steady above $ 1,300. Oil and other commodities are showing signs of a possible rebound. This could, in the best case, be signaling improving global growth, but these markets could also attract investor money once it becomes clear that equities have peaked.
The nature of markets means that all this could take two weeks, two months or two years. The quicker this long-impending cloud works its way out of the system, the better it would be for everyone, particularly India, where it would clear the way for lower interest rates, a weaker rupee and a slow but inexorable pick-up in domestic investment.
The author is CEO, Mecklai Financial