RBI faces a currency conundrum

The rupee has appreciated 6.3% against the dollar since the beginning of this year

The rupee’s sharp appreciation against the dollar has given traction to calls for the Reserve Bank of India (RBI) to intervene to ensure the domestic currency finds its fair value.

The RBI has said it intervenes in the currency markets to smoothen out excess volatility. But this strategy might be responsible for the deluge in foreign capital flows and the consequent strengthening of the rupee. Foreign investors have been net buyers of Rs 1.28 lakh crore worth of debt since the beginning of this year, having almost exhausted their quotas for government and corporate bonds.

The rupee has appreciated 6.3 per cent against the dollar since the beginning of this year. The RBI’s trade weighted real effective exchange rate, which adjusts for exchange rate movements of its 36 partners and inflation differentials, was at 117.89 at the end of July. This led to many arguing that Indian exports have been rendered uncompetitive.

But why has the rupee appreciated so sharply? Some economists hold the decline in currency volatility responsible for the deluge in foreign flows.

The accompanying chart, which shows annualised currency volatility since 2000, identifies four phases. The first, which began in early 2000, was characterised by low volatility. This phase ended in early 2004. Volatility rose, although modestly, till around mid-2008. Volatility surged around the financial crisis of 2008, settling at a higher level thereafter. But it has declined over the past few years.

This decline essentially lowers currency risk for foreign investors, which economists say is akin to giving them an implicit guarantee. This, coupled with the high real interest rate differential, led to the capital flow surge in the debt market, say some economists. “As long as volatility is low, and there is an interest rate differential, it makes sense to invest,” says Suvodeep Rakshit, economist at Kotak Institutional Equities.

Some economists say falling volatility has been seen in other emerging markets as well, which have also seen strong portfolio flows.

“Across emerging markets, currency volatility has gone down,” says a senior economist at a private sector bank. “This encourages all sorts of carry trades. You borrow in cheap currencies and invest in emerging markets. It is liquidity driven, too, fuelling debt inflows. And currency appreciation increases returns.”

Should RBI intervene?

The RBI has routinely intervened in the currency markets. Gross interventions spiked at the turn of the millennium, under Bimal Jalan. Under Y V Reddy, interventions rose around the financial crisis of 2008. Interventions spiked in 2013 as the RBI, under Raghuram Rajan, fought to defend the rupee. Under the present governor, Urjit Patel, interventions soared in November 2016, when demonetisation triggered a capital exodus. Foreign institutional investor’s had pulled out Rs 19,603 crore in November and Rs 18,903 crore in December from the debt markets. RBI’s interventions declined after that but has gone up in recent months.

Some economists argue for greater interventions to ensure the currency finds fair value. But the liquidity surge could be a problem. “Under normal circumstances, the RBI could have intervened even more. But after demonetisation, the surge in rupee liquidity makes it difficult for heavy intervention,” says Rakshit.