Jamal Mecklai: A dog chasing its tail

MARKET MANIAC

Looking at the recent rise in foreign currency reserves makes it apparent that the last sharp fall in the rupee was engineered by the RBI. Since January 2003, there have been three instances of sharp rupee declines""from early April 2004 to the end of July 2004 (when it fell from 43.50 to 46.50); from mid-August 2005 to early December 2005 (when it fell from, again, 43.50 to 46.25); and finally recently, from mid-March 2006 to mid-July 2006 (when it fell from 44.50 to 47).

During the earlier two declines, the reserves remained more or less steady, actually rising by a modest $1.8 bn and $0.8 bn, over the respective 4 to 4-1/2 month periods. These are very small numbers, certainly compared to the rise in reserves when the rupee was strengthening. Clearly, during both these declines, market demand for dollars was greater than supply and this drove the rupee down to a level that balanced the two.

The recent fall of the rupee, however, was quite different. It was accompanied by a sharp rise in reserves""they rose by nearly $17 bn over four months, a rate that was within 10 per cent of the highest rate of reserves growth seen over the past few years. While part of this increase in reserves was due to the fall in the dollar internationally (which resulted in an increase in the dollar value of reserves held in other currencies), this would have had a very minor impact. Assuming (for convenience of calculation) that the non-dollar reserves were all held in euros, the revaluation impact on 100 per cent of our reserves would be only around $7.5 bn. Now, since the bulk of our reserves is still held in dollars, the revaluation impact is certainly less""and probably much less""than that. This would suggest that over the past four months, the RBI bought somewhere between, say, $13 bn and $15 bn.

Now, $15 bn over four months is not a lot of money""hah! Well, that is in comparison with the domestic forex market that trades easily $15 bn a day! Thus, the $15 bn bought by the RBI over four months would contribute only about 1 per cent to the total domestic forex turnover. However, even such a modest imbalance could drive prices quite sharply, particularly if the market is positioned adversely. Ever since the rupee turned turtle in 2002, the market has imbibed the prospect of rupee strength, and for most of the period since, the market has been positioned either short or very short dollars. This could be because there are many companies that have 100% (or close to 100%) exports; they would doubtless be very keen to sell since rupee strength would affect their business disproportionately as compared to companies that are net short foreign currency (since imports seldom comprise such a high percentage of any company's business). Further, the RBI's loud effort at preventing rupee strength""the steady buying of dollars""serves to reinforce the belief that the rupee is intrinsically undervalued. While this is probably true over the medium to long term, markets move based on short-term supply/demand forces and market users need to continuously tune their positions based on their targets and on "live" short-term views.

In any event, it is hard to understand why the RBI would be buying dollars so aggressively. Exports were""and are""doing fine, despite the appreciation in the real effective exchange rate, which clearly does not correct for the impact of improved productivity, better (albeit marginally) infrastructure, etc. on export competitiveness. Perhaps, the RBI was worried that the market was getting concerned about the current account deficit""remember, at the turn of the year, there was talk that the current account deficit could cross 3% of GDP (in the event, it was well under 2%)""and that rather than let the market drive the rupee lower, it might be better to engineer the decline itself, reiterating its old-fashioned belief that a group of intelligent, focused and well-intentioned people can do things better than the market, which is merely hundreds and thousands of people putting their money where their mouths are.

Another positive of a weaker rupee could be the supercharging growth of the services sector, which remains a key contributor to job growth. On the flip side, of course, is the fact that the dollar buying has caused a huge bubble in money supply, which, today, is running much higher than the RBI's plans. Higher money supply growth leads to higher inflation, and bubbles in asset markets""read, real estate. Again, with global inflation on the rise, the weaker rupee (which is also the result of dollar buying by the RBI) pushes up domestic inflation yet again. This is all the more so since prices in India today are much more import-sensitive""imports comprise around 15% of GDP""and thus a weaker rupee feeds into inflation much faster than it did, say, five years ago. All this, of course, forces the RBI's hand on raising interest rates.

The net picture then is of the RBI buying dollars to weaken the rupee (to sustain strong export growth?); this pushes money supply growth up, which contributes to higher inflation, which in turn, requires the RBI to raise interest rates, which, of course, cools lending and growth.

Sounds a bit like a dog chasing its tail, doesn't it?