Most believe that the rupee will not fully recover lost ground after the recent turmoil and that the forex market will remain volatile for some time to come.
Last week will go down in the history of the foreign exchange market as one of a series of significant events. The net result of these events was that the rupee to the dollar came down to its 18-month low. And it threatened to remain lower than the level the week before. The events raise a number of issues about the foreign exchange market, even as it throws some light on the future course of reforms needed in this market.
The series of events began with a statement made by S S Tarapore, former deputy governor of the Reserve Bank of India (RBI) and the author of the capital convertibility report. He said the rupee was overvalued and needed correction, otherwise exports would suffer. Immediately came a retort from C Rangarajan, the RBI governor, who said that the natural tendency of the rupee was to appreciate because of capital flows and that the RBI had to intervene to keep it down. Next came the by now famous speech of Y V Reddy, deputy governor of the RBI, who told a gathering of forex dealers in Goa the previous week that the rupee was in fact overvalued in terms of the real effective exchange rate (REER) and needed to be corrected. The last straw was the statement made by the prime minister Inder Kumar Gujral in an interview to a newspaper where he was quoted as saying that the exchange rate management policy would undergo a change and that the rupee-dollar parity will continue to be fixed in a band. He added that
the Tarapore Committee had suggested such a change.
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The PMs statement that appeared last Wednesday brought down the forex market like no other factor - including the RBIs intervention - could do. The market believed that the government was trying to prepare the ground for a heavy depreciation of the rupee. And in no time, the rupee lost several notches in its value against the US dollar. It fell steeply from Rs 35.71 to a dollar on Tuesday to Rs 36.15 to the dollar on Wednesday. And despite the RBIs clarification, in effect ruling out any possibility of a band, the rupee refused to recover lost ground. The RBI maintained that the dollar would continue to be determined by the market, yet the market somehow did not accept it. As inter-bank speculation became stronger and corporate demand added to the pressure, the rupee baulked and reached 36.35 on Thursday. On that day, the State Bank of India (SBI) was reported to have bought $ 250 million from the market, while unconfirmed reports said that Reliance Industries Ltd too bought $ 50 million in the forward market.
The surprising aspect was that the central bank did not intervene in the market on this day. And on Friday which happened to be a market holiday in Mumbai, the commercial capital of the country, the local currency came down even further to 36.50, before closing at 36.20. The stronger closing was the apparent result of the RBI intervention in the market on that day. Net, the rupee lost 71 paise in a matter of four days - a loss of 1.5 per cent.
As the market perception underwent a change, corporates rushed to cover their position. This led to the strengthening of the forward market, with premia slowly inching up. The six month premium on the dollar rose from 6.05 per cent before the crisis to 7.69 per cent, and further to 8.36 per cent as the volatility became more acute.
The most astounding part of the story is the speed with which the market perception of the rupees strength changed. All along, the belief was that the rupee would become stronger if the RBI did not intervene in the market. Corporates and banks shared the vision of a rock steady rupee against the greenback, with many corporates forgoing the hedge option. This no doubt saved them some cost, but the basic belief was quite clear.
All this collapsed like a house of cards once the rush began. And in retrospect, the markets logic appears sound. The rupee fundamentals were always weak, says Ravi Vasantraj, vice president, Mecklai Financial and Commercial Services, a leading forex brokerage house in Mumbai. Other forex dealers point out that the forex market in India is still narrow and shallow. As it lacks depth, the market becomes susceptible to rumours and even small provocations. The forex markets resistance level is low, says a dealer. It also encourages speculation. The rupee declined last week because the forex market is a speculators market. All the statements made in context of the market provided fuel to the speculative activities, says K S Harshan, vice president, ICICI Bank.
As market players explain the game, the RBI has always tried to talk the rupee down, with limited success. To prevent an appreciation of the rupee, the central bank has continuously been intervening in the market, mostly purchasing the dollar. In fact, between April and July, it had bought as much as $4.6 billion from the open market. Any intensification of the endeavour would exacerbate money supply and tilt the applecart of the government which wanted to keep inflation down. In the meantime, the steady rupee had led market players into a degree of complacency. The market was oversold and had a lot of exposed positions, says Luis Miranda, vice president, HDFC Bank.
As the market perception changed, the central bank had to reverse its process and it rushed in to support the rupee. In a matter of four days days last week, it is said to have sold $ 100 million to 150 million in the market.
And talking of panic, most players agree that the forex market in the country is too thin, making it vulnerable to various pressure points. The players are too few, and the business volumes are too small for it to be a viable, vibrant and strong market. As the figures released by the RBI every week show, the average volume of business has, for quite sometime, been in the region of barely 2.5 billion dollars per day. Considering the trade volume as also the forex reserves, this volume is hardly significant, point out market players. And it pales into insignificance when compared with the trillions of dollars traded every day in the international markets. As a further dose of reforms, the RBI and the finance ministry need to add to the number of players, which alone can deepen the market, they add.
Even as speculators took advantage of the panic and made a killing, exporters and importers got bruised in the process. As dealers point out, this community had taken the stability of the rupee for granted, based on their experience for the last one year. The sudden decline in the rupees value caused heavy losses for importers who will now have to pay more for their dollar-based imports. Exporters too would tend to lose potential gains if the market turbulence continues.
Another offshoot of the volatility in the forex market was the firming up of premia in the non-deliverable forwards (NDF) market. The NDF market offers a hedge facility to FIIs and NRIs who invest in the Indian market. Until now, they were not allowed to hedge their position domestically. Last week the RBI allowed them to cover their risk in debt instruments, but equity is still out of the purview of this scheme. As the rupee value dwindled, they rushed to cover their equity positions, with the premia rates rising from 10 per cent to 20 per cent for contracts of a year. The NDF market thus provided for ample arbitraging scope, considering that premia in the domestic markets are much lower at around eight per cent.
In the hurry to protect their exposure, the FIIs began unloading their investment in the stock market. Any unhedged exposure would have meant capital loss for them. And in the process they brought the Sensex down by nearly 150 points last week. The position in the securities market was the same, where they preferred to exit out of their holdings, in the process bringing down the prices.
Some players look at this turmoil from a different perspective. Since the REEF (exchange rate adjusted for inflation) has declined by nearly 14 per cent since March 1993, the rupee indeed needed to depreciate, they point out. The REEF basically indicates the difference in price of an identical basket of goods and services. In this perspective, the decline in the rupees value is a good thing, as it would bring the rupee to its realistic level and make exports more competitive, according to them.
The central banking sources, on the other hand , point out that even though depreciation of the rupee is desirable, it is the volatility that needs to be guarded against. Nevertheless, the fact remains that the rupee has slid by a mere 70-odd paise in the last one week, amounting to a depreciation of no more than 1.5 per cent. Currencies like the dollar, pound or yen take this amount of depreciation in their strides, point out some players. So, this is merely a storm in a tea cup, they feel. The panic is just because we have lived in a regime of exchange rate stability which is basically artificial.
Where do we go from here? Market players are almost unanimous that there is little scope for the rupee to fully recover the lost ground. We will not see the rupee at the 35.71 level for a long time, points out a dealer. Most of them believe that rupee will now stabilise around 36.25 to a dollar. It was lack of demand for the dollar that had prevented the rupee from depreciating on its own. This situation seems to be reversing in the eyes of the market. For one, the hike in oil prices seems inevitable. And once the hike is announced, the oil companies will start buying dollars from the market to pay up their dollar liabilities, points out Ravi Vasantraj of Mecklai.
So far this demand was not reflected in the market movements because oil companies were not allowed to hedge their position domestically, he explains. There are others , essentially in a minority, who feel that the rupee will slide back in a few days. Harshan, for example, feels that rupee will stabilise around 36. P R Joshi, senior adviser, DSP Merril Lynch, says the rupee will bounce back over a longer period depending on the inflow of foreign capital.
As of now, signs are that the flows will strengthen, paving the way for a stronger rupee. However, stability of the market is a different thing. As demand for the dollar continues to move northward, the volatility will accentuate. Players ought to be ready for this eventuality.
The most astounding part of the story is the speed with which the market perception of the rupees strength changed in a short span of time.
The forex market in India lacks depth and its resistance level is low because of which it is susceptible even to rumours and small provocations.