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The rupee: Nearing 80? RBI’s action indicates we could see volatility spike

If the off-meeting rate hike does indicate that RBI is having difficulty managing its intervention, we could see volatility spike

In the event, the rupee actually strengthened because while the US rate hike was already built into market expectations, the rise in rupee interest rates was a surprise.
In the event, the rupee actually strengthened because while the US rate hike was already built into market expectations, the rise in rupee interest rates was a surprise.

I will be 72 this year, but I often tell people I am nearly 100, which, in a sense is true—I am closer to 100 than I am to 40, for instance. But, I acknowledge that 80 is probably a more reasonable approximation, and these days it is beginning to look like that for the rupee as well. RBI’s surprise off-meeting rate hike on Wednesday was clearly timed to protect the rupee from any untoward movement later that day when the US Fed’s widely telegraphed rate hike was expected, and, indeed, was delivered. In the event, the rupee actually strengthened because while the US rate hike was already built into market expectations, the rise in rupee interest rates was a surprise.

Nonetheless, the sense of nervousness shown by RBI—the suddenly awakened rhetoric about prices when just a month previously they were quite sanguine about inflation—suggests that it is likely that its intervention in the FX market was getting more and more difficult. FPIs had pulled around $25 billion out since November last year—incidentally, bringing total FPI flows to the same level as October 2019 —and reserves had fallen by $45 billion since then. This was the largest decline in reserves since the 2008 crisis, when reserves fell by nearly $70 billion in about 6 months, representing over 20% of our then stock of reserves. While the current loss of reserves (around 8%) is much less threatening, the reality is that this crisis is not yet over. So, the question is whether the rupee will finally fall through the 77 level that RBI has so lovingly set up and head towards 80, or whether it will, once again, defy the odds and climb back towards 74 or 75? Given the tragic state of the world and the volatility in global financial markets, I believe the odds must be in the favour of a weaker rupee.

First of all, the rupee has already been holding relatively firm against the raging bull dollar—the dollar index (DXY) is up by over 14% since January 2021, while the rupee has fallen only about 4.5%, largely, of course, due to RBI’s efforts. At some point, the rupee will have to catch up with the market. More importantly, though, the forces that have pushed the dollar higher remain ever actively in play. Putin’s war continues to spread destruction in Ukraine, increasing panic in its European neighbors—energy and commodity prices are soaring and, truth be told, nobody knows how—or when—this will end. Putin is crazy enough to actually use nuclear weapons, and while that would certainly end the war, the fallout from that is as incomprehensible as it is horrible. Thus, today at least, the dollar as a safe haven stands alone.

Perhaps more directly, US inflation is far from being tamed. The Fed stands ready, it says, for at least two more 50 bp hikes at its next meetings, but it is well recognised and widely acknowledged that the Fed is struggling to stay on top of the inflation ball. Thus, while the equity markets reacted positively to the rate hike, it is hard to believe they will remain in a good mood as rates continue to rise, particularly if, as I expect, inflation proves difficult to contain.
Thus, equity markets will weaken but the dollar will remain strong till such time as markets see a sustained slowdown in growth, at which time, I would expect the dollar to weaken as well. I note that US growth was negative 1.4% in the last quarter, well below expectations of 1.1%, but markets, surprisingly, did not seem to see this as something to be particularly concerned about.

Inflation is clearly the bigger bugbear, indicating that inflation expectations are already lit; there is a greater focus on the employment numbers and wage increases than on business performance and growth. There is a broad sense that the world is slipping into stagflation—a prolonged period of higher inflation and sub-optimal growth, a la the 1970s and 1980s. India is, of course, in a difficult place. Growth is holding on, but with commodity prices high and unlikely to come down any time soon, it is only a matter of time before we, too, see growth slipping. Exports are doing well but imports are growing even more strongly—commodity price inflation is a big player in both these numbers. There are doubtless more interest rate hikes on the cards, but given our weaker financial sector linkages, RBI’s ability to control inflation is weaker than the Fed’s. Indian interest rates will rise less—and, possibly, much less—than US rates over the next 12-18 months, which translates to more pressure on the rupee and RBI. Rupee volatility has already risen but is still reasonable, courtesy RBI. If the off-meeting rate hike does, indeed, indicate that RBI is having difficulty managing its intervention, we could see volatility spike and, perhaps, we could ultimately be looking downwards towards 80.

The author is CEO, Mecklai Financial
http://www.mecklai.com

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