Better not step in

Indian Express, 2 October 2011

The recent sharp movement of rupee dollar exchange rate is part of the turmoil in world markets, which are currently witnessing large currency flows. In coming months, world economic conditions may lead to a further increase in cross border flows, and currency markets may see even sharper movements.

Now that India is open in many aspects, currency volatility will have an impact on many dimensions of economic activity. The Reserve Bank of India will come under pressure to intervene in currency markets by those who stand to lose.

Most recently we have seen pressure on the RBI to prevent rupee depreciation. The are two big losers on account of depreciation. First, importers would now have to pay more for the same dollar value of imports. To some extent, it is possible for importers to hedge their currency risk. However, since hedging is costly, it is often incomplete, and sharp depreciations lead to a sudden increase in costs of importing.

Second, firms holding dollar debt will have to shell out more rupees both for interest payments and the principal. Cheap dollar loans and relative currency stability often make dollar loans appear attractive, and depsite the currency mismatch on their balance sheet, firms often take the risk of borrowing abroad. In recent days, despite the turmoil in global currency markets, India has witnessed a large increase in External Commercial Borrowings (ECBs). This could potentially lead to difficulties for these firms later, as such borrowing is often fully or partially unhedged on the currency side.

In addition to straight-forward ECBs, which are foreign currency loans, where companies are betting on currency movements, Indian firms have also been betting on the movement of the stock market. This is done through selling Foreign Currency Convertible Bonds (FCCB). An FCCB is a mixed instrument. Like a bond there are regular coupon and principle payments, but in addition, the holder of the FCCB has the option to covert the bond into equity at maturity. If the equity price is higher than the contracted conversion price, this is attractive for the bond holder. If the stock price is lower, the bond holder asks for the pre-agreed conversion price. FCCBs were a preferred instrument for raising money when the currency was appreciating and the stock market rising, especially during 2002 to 2007. However, with the stock markets down, and bond holders demanding the pre-agreed upon conversion price, many companies are worried. In addition, since the principle has to be returned in dollars, the depreciation of the rupee adds to the woes of the bond issuers. Consequently, the pressure on the RBI to prevent depreciation is even greater as stock markets have declined and bankruptcy of a large number of firms can be devastating for Indian industry.

An equally important argument in favour of preventing depreciation is the role of currency in inflation. A large part of Indian GDP is now tradable, that which can be traded, even if it is not. Industrial inputs, oil, capital goods and raw materials are tradables. Given the openness of the economy, producers can choose to buy these goods in world markets, or in the domestic economy. Competition ensures that the prices of these goods are determined by world prices and the exchange rate. An exchange rate depreciation makes tradable prices more expensive. In the current high inflationary environment when RBI is trying to fight inflation, one way to do so would be to prevent depreciation. Hence, there is another argument to intervene.

On the other side of the coin are the exporters, who gain from a currency depreciation. For many years when there was pressure on the currency to appreciate, there was pressure on RBI to prevent appreciation. This the RBI did, until the resulting liquidity gave India a difficult and persistent inflation problem. When the pressure on currency appreciation went away with the onset of the global financial crisis, the clamour for RBI intervention in currency markets subsided. In a period when world trade witnessed large shocks, when Indian exporters would normally have been asking for help from the RBI, a weak rupee must have been a relief. Other than selling dollars in early 2009, when there was a severe shortage of dollars, liquidity and trade credit, the RBI was able to largely stay away from currency markets. Currently the Indian economy is expected to slow down, especially on the investment front, and any help from a weak rupee that is seen as helping exports, is a blessing for GDP growth.

So what should the RBI do? Assuming that it can intervene effectively in currency markets and prevent depreciation, should it do so? This strategy, may be effective in the short run in preventing firms who have borrowed and importers who have contracts to import, but in the longer run it will encourage firms to take on unhedged currency risk as they will expect the RBI to step in when the rupee weakens. The problems of the world economy are not over and can be expected to last a few years. The world is likely to see turmoil both in currency markets and in economies. Providing incentives for firms to undertake higher currency exposure, especially in such times, should be discouraged and not encouraged.

Can RBI intervene effectively to prevent depreciation? One difficulty is the size of the rupee's foreign exchange market today. Estimates suggest that the spot and currency derivative markets trade between USD 40 to 75 billion a day. For effective intervention that would impact prices, RBI would need to intervene to the extent of at least a 10 percent of the size of trading in the market, or an average of USD 5 billion a day. Reserves of USD 250 billion can last for two months. Unfortunately such strategies are usually unsuccessful as markets expect the central bank to give up intervention before reserves go to zero. This leads to capital flight and a sharper, quicker depreciation than would have happened without the intervention.

The RBI appears to have stayed away from any large scale intervention in currency markets in recent days. It would be wise to continue this strategy despite the clamour for intervention it may witness.

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