Bibtex
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In the parlance of global investors and analysts, the Indian rupee is one of the high-beta currencies of the world. In plain language, it implies that the rupee has high volatility and adverse risk-return characteristics. One implication of this feature is that the probability of a fall of the rupee over the next one year and beyond is perceived to be higher than a rise. This perception gets accentuated at times of volatility through a positive feedback process.
The high beta characteristic of the rupee results in both foreign and domestic investors requiring a risk premium for investing in rupee assets. Other things being equal, this means a higher interest rate in India.
Although the long-term average annual depreciation of the rupee vis-a-vis the US dollar in the period since its becoming market-determined in March 1992 was lower compared to what was the case before, periodic bouts of sharp volatility have been a feature of the domestic forex market in India ever since. The last such experience was in August, 2013 caused by frailties of slowing growth, rising inflation and a widening current account deficit that were exacerbated by prospects of monetary policy reversal by the Federal Reserve at that time.
The improvement in the external sector fundamentals and the relative stability of forex market since then resemble those of similar periods in the past which were, however, eventually punctured by bursts of volatility and sharp adjustments of the nominal as well as the real exchange rates of the rupee.
Better structural stability in the domestic forex market will create conditions for the removal/relaxation of the slew of archaic capital controls that now drive a wedge between residents and non-residents as regards their access to it. Those controls engender distortions in the pricing of forex products, especially the derivatives, among others.
In the past, both the government and the RBI would routinely claim after episodes of fall in rupee's exchange rate that there would be little or no adverse implication for growth, inflation and budgetary position. But the facts turned out to be different, especially for inflation and fisc.
A poignant illustration in this regard is provided by the ballooning of government's liability in the decades following the receipt of US dollar 470 million in early 1989 from Union Carbide for damages caused in the Bhopal disaster a little over four years back. This amount was sold to RBI and, by court orders, the rupee proceeds were invested in a special long-term government bond carrying interest @ 12 per cent with a proviso that both the principal amount as well as the interest will be protected against any fall in the exchange rate of the rupee.
Thus, in effect, the government took upon itself the liability of a long-term US dollar bond but carrying rupee rate of interest. The fiscal implications of this arrangement due to the fall in the exchange rate of the rupee, which was about Rs. 15.7 to a dollar in early 1989 over the next twenty years or so during which compensations were paid to the disaster victims were enormous. The aggregate compensation paid by the government during that period amidst the rise of the dollar by about 225 per cent against the rupee was several multiples of the initial rupee proceeds.
The main reason for the secular fall in the exchange rate of the rupee over time, including in recent years, has been higher inflation in India vis-a-vis its trading partner countries. Viewed from this perspective, a vicious cycle of inflation-depreciation-inflation is still discernible in India, albeit in a longer time frame than in the past. For addressing the structural reasons underlying this aspect, it is imperative to implement an inflation-targeting monetary policy framework at an early date.
The primacy of inflation management in setting the external value of rupee could be understood in the light of the fact of lower average annual depreciation of the rupee in the post-reform era being largely the result of a better inflation performance during that period. The comments of the RBI Governor Raghuram Rajan in recent months to the effect that low inflation is a prerequisite for a stable rupee is a belated but very important recognition of an economic reality. Anchoring of inflation expectations by way of a credible and consistent monetary policy framework will also cushion to some extent the risks to external flows from further monetary tightening in US.
Better structural stability in the domestic forex market will create conditions for the removal/relaxation of the slew of archaic capital controls that now drive a wedge between residents and non-residents as regards their access to it. Those controls engender distortions in the pricing of forex products, especially the derivatives, among others. And they provide the raison d’etre for the offshore non-deliverable forward (NDF) market.
The rising trade volumes in the off-shore NDF markets in places such as Singapore and Dubai as well as the increasing role of those markets in the discovery of the exchange rate of rupee are legitimate concerns. Intervention in the offshore forex market, though not impossible, is fraught with legal and operational hurdles. India does not have the advantages which China has in this regard in the form of its Hong Kong SAR. But India can learn from the Chinese experience in promoting the use of the rupee in trade and investment transactions with non-residents which can be a stabilising force for the forex market. The recent listing of rupee bonds and rupee-based fixed income ETF in London are encouraging signs in this regard. All in all, it's time for expeditious monetary policy and forex market reforms.
(The writer is a finance and risk management specialist. He is a former central banker)