By Jamal Mecklai
Over the past couple of years, as the Reserve Bank of India (RBI) has actively driven USD-INR volatility down to almost invisible levels, I have had an intuitive sense that this approach is basically flawed for two reasons. First, volatility is a mean-reverting property of the price of any asset in a reasonably open market. If it falls sharply (to near-zero), it is certain to bounce back viciously at some point, which could dramatically injure some users of the market—call this the moral hazard problem. The second nervous-making reason is that with volatility being extremely low, option prices are extremely low as well and, in the event there is a breakout, banks, who have sold options, could end up with a lot of red ink.
Of course, the key phrase here is “in the event there is a breakout”. The RBI appears to be sanguine that its reserves are strong enough to prevent any such contingency. But the very nature of unforeseen events is that they can’t be forecast — they are called black swans.
Consider the (not so) outlandish possibility that Donald Trump becomes president of the US and imposes incomprehensibly punitive tariffs on imports from India because India has been running a trade surplus with the US for two years — recall that during his earlier term the US treasury had looked at whether India was a currency manipulator. As a result, exports could collapse, triggering a run on the rupee that all the RBI’s horses and all the RBI’s men would not be able to prevent; not only that, we would lose, perhaps, hundreds of billions of reserves that we have so painstakingly built.
There have been a couple of other analysts who have been arguing similarly that the RBI’s approach to managing the rupee is flawed. A particularly revealing argument was reported earlier this week. An analysis by Josh Feldman and Arvind Subramanian showed quite elegantly that prior to 2019, the RBI’s policy was to allow the rupee a constrained float, ensuring that volatility was subdued relative to the global currency market. This was done to enable users to manage their risk in the relatively lower liquidity conditions that prevailed here.
This was accomplished by allowing (controlled) depreciation when outflows pushed the rupee lower, and building up reserves while permitting some appreciation when inflows plus strong export performance enabled this. The net result was a steady rise in reserves (except for a brief decline during the global financial crisis in 2008) and a reasonably competitive real effective exchange rate (REER), which averaged 92.6 between 1994 and 2018. The proof of this pudding was the fact that exports grew during this period at an annual average rate of over 10%.
In contrast, since 2019 (and the apparent new policy), the REER has appreciated sharply, averaging 100.1 till 2024; unsurprisingly, export growth has fallen to an average of less than 5% a year. To be sure, the reserves grew at an even faster clip than before, since the vast bulk of inflows were fed in as virtually zero appreciation was permitted. However, the volatility of the reserves increased sharply with the RBI losing over $100 billion over six months in 2022, $25 billion over three months in 2023, and nearly $20 billion over just the past month.
With multiple threats of increasing volatility in the near future — the results of the US election and its aftermath, the explosive possibilities in Wesu Asia, Russia’s increasing belligerence, and, of course, China, inscrutable as ever — and the USD/INR market appearing to reach a nodal point (volatility at an all-time low of 1%), the RBI’s approach may be reaching a critical test point.
A frightening truism in markets is that it is impossible to maintain an open capital account, independent monetary policy, and a floating exchange rate — you can have two but not all three.
With US inflation showing renewed signs of life, particularly as many analysts are focusing more loudly on the exploding budget deficit, it seems clear that US interest rates are unlikely to fall as sharply as had been anticipated. While our exchange rate is ostensibly floating, the reality — which is what markets see — is that it isn’t. This approach may compel the RBI to keep domestic rates higher than necessary (as many analysts already believe) or indeed, to find ways to close off avenues of convertibility (as has already been seen in the TDS on heretofore permitted capital outflows). It’s more than time to change.
The author is CEO, Mecklai Financial.
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