The most significant event in the Indian FX market in 2016 was RBI Governor Raghuram Rajan’s surprise decision to demit his office before his term was up.
The most significant event in the Indian FX market in 2016 was RBI Governor Raghuram Rajan’s surprise decision to demit his office before his term was up. While it had marginal impact on the immediate value of the rupee both on the announcement (in June) and in the event (in September), it has increased uncertainty, at least in terms of how RBI would act in the face of any destabilising events in the future, whether global or domestic.
Rajan had frequently enunciated his intention to build up FX reserves, recognising that the only meaningful defense against heightened rupee volatility in a global crisis was having sufficient reserves to prevent a free-fall, perhaps remembering the situation he inherited when he took charge. Over his three year term, India’s FX reserves rose by over 33%, from $275 billion to nearly $368 billion when he demitted office. While building the reserves, he had several occasions to use them to defend the rupee, as he successfully guided the currency lower—from the high of 58.50 it hit after Narendra Modi’s election to around 68.50 at the start of this year (coincidentally, very close to the level that prevailed when he first took charge). He was also successful at constraining rupee volatility; by 2016, the average volatility was down to just 4.8% in 2016, the lowest it has been in any calendar year since 2006.
The new governor appears to be attempting to maintain a similar strategy, buying and selling dollars to keep the rupee in the narrowest possible range; volatility fell even further, reaching its lowest level since 2004, on November 7. However, the double whammy the next day of Trump’s election and our own government’s political punt with demonetisation saw rupee volatility shoot higher, threatening to break through this long-term average. Reserves, too, have declined, falling about $8 billion from an all-time high of $370 billion reached on September 30, and the rupee once again tested its all-time low of 68.90.
While things have calmed down a bit since then, the global investment environment has certainly changed from the benign modestly-risk-on one we have lived in over the past few years. While markets have quite comfortably weathered several dramatic events—Brexit (which wrecked the pound), the Trump victory (which had—and still has—everyone wondering about the future), and the Federal Reserves’ December 14 rate hike (with loud promises of more to come), volatility in most global markets is, unsurprisingly, higher.
The dollar index, which took off right after Trump’s election, hit a multi-year high (at 103) and, given that the Fed has announced that it expects to raise rates three times in 2017, the broad expectation is for it to keep climbing. Oil is also showing some strength, which adds to the increasing belief that US—and thence global—inflation may well become an issue after a long time. In the meantime, the US equity markets are flirting with the magic Dow 20,000 mark, and many are seeing a replay of the wild bull run post-Reagan or even post-Greenspan’s “irrational exuberance” comment in 1996.
Could this be the last blast upwards before another serious decline, a la-2000 or even 2008?
It is hard to make the case that Trump’s election is going to put everything right, even for the US. Indeed, Congressional opposition, which had been shocked into silence on his victory, is beginning to find its voice, and it is likely that many of his wild schemes will have difficulty getting off the ground. His petulance at even being questioned could well boil over sooner rather than later, leading to more uncertainty. Other volatility-inducing factors include the certainty of increased political turmoil in Europe; and China, which is looking nervously off-balance as its reserves are dwindling rapidly.
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The domestic scenario, too, could end up dictating to markets much more than it has in recent years, adding to the potential turmoil. It is impossible for anyone to forecast how demonetisation will play out, but it does seem clear that growth is going to be much lower than expected. While other benefits may, indeed, come to pass, the pathetic implementation of this hardly-necessary shock has disillusioned most people—particularly as the government continues to show zero empathy in downplaying the truly difficult situation many people have been put into—and has seriously wounded the government’s popularity. The only good news in all this is that the Election Commission has become emboldened to push for reforms of political parties, their funding and their expenses. We all need to support this as vocally as we can.
All in all, it seems like a reasonable bet that 2017 will be more volatile than 2016, both globally and domestically. The rupee, in particular, will have a difficult time, not least because RBI’s credibility has been weakened by its fumbling over “notebandi”. Filling Rajan’s shoes was never going to be easy, and the new governor and the MPC have yet to show themselves to be truly independent and strong stewards of India’s macro-economy. Look for higher rupee volatility and a range of 66 to 72 in 2017.