Beating the rupee down: Why the RBI can't do much about it

After teetering on the brink of Rs 50 on Friday, the Indian rupee pulled back to close at Rs 49.43 against the US dollar. How much worse can it get?

In a global macro scenario of risk-aversion, the only way the rupee can be coaxed up or stay steady is through an intervention by the Reserve Bank of India (RBI). Why is RBI Governor D Subbarao sitting on his hands when his currency is beaten black and blue?

On Friday, when the rupee was dangling on the cusp of 50 to the dollar, RBI Deputy Governor Subir Gokarn said the RBI’s job was to smoothen volatility, not manage the exchange rate. He said: “We, at this point, do not see any intervention from a rate targeting viewpoint. That is something that would reflect a change in policy stance, which we are not doing at this point.”

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In fact, Gokarn went further and said even the fact that the rupee’s fall was worsening inflation was not enough to push the RBI to intervene actively. “One should not look at our exchange rate policy within the narrow boundaries of inflation management,” Gokarn told CNBC TV-18.

[caption id=“attachment_91495” align=“alignleft” width=“380” caption=“If a dramatic swing of the rupee by 12-13 percent in less than eight weeks (on 1 August the rupee was at 44.07) is not reason enough to act, what is? Jayanta Dey/Reuters”]  [/caption]

Finance Minister Pranab Mukherjee said the RBI would intervene in the market “as and when the situation warrants”, but “right now there is no such situation”.

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If a dramatic swing of the rupee by 12-13 percent in less than eight weeks (on 1 August the rupee was at 44.07) is not reason enough to act, what is?

Reading between the lines, one can interpret the RBI’s masterly inactivity on the rupee in three ways: it either wants the rupee to go down; or it does not have the ammunition to fight the rupee’s dramatic collapse; or it is conserving its resources for later, when things might get worse.

The first reason does not make sense since the RBI has been hawkish on inflation and is aggressively raising rates. The fight against inflation has been seriously compromised by the fall in the rupee. Even as commodity prices are falling worldwide, our domestic costs - especially of fuel - are rising, as evidenced by the recent Rs 3 hike in petrol prices. A stronger rupee will help the RBI fight imported inflation better.

The second reason - that it does not have the ammunition - is also unlikely, for current foreign exchange reserves are around $316 billion, enough to defend the rupee.

This leaves us with the last reason. Is the RBI conserving its forex resources for a rainier day, assuming last week was not rainy enough for intervention?

A look at what happened in 2008-09, when the world market was turned upside down by the Lehman collapse, is instructive.

In the 12 months between June 2008 and May 2009, when the world was smelling a crisis and then duly tumbled into one, risk aversion peaked and the RBI had to step in and sell a gross $ 65 billion - yes, $65 billion - and a net $44 billion to ensure that there was no panic in the foreign exchange market.

If it is expecting to buy $44 billion this year - or more - it is right to hold its hand on defending the rupee.

The composition of India’s foreign debt and hot money flows is also critical to an understanding of why the RBI is cautious about throwing good money to protect the rupee.

[caption id=“attachment_91496” align=“alignright” width=“380” caption=“It is more than likely that the RBI is conserving its assets for a worst-case scenario as in 2008-09, when it had to sell $44 billion to smoothen the currency market. AFP”]  [/caption]

As on 31 March 2011, India’s short-term foreign debt equalled $65 billion - around 22 percent of our total external debt. The position would not have changed much since then.

Moreover, we also have over $100 billion of foreign institutional investor (FII) money invested in the stock and debt markets. This money can easily flow out if the western capital crisis suddenly worsens.

Add the two components together and the potential worst-case scenario is an overhang of $165 billion (short-term debt, and FII money) that could leave all of a sudden.

Of course, it won’t happen that way, for India is really the place to be for foreign investors. But short-term panics cannot be ruled out. In 2008-09, for example, the FIIs withdrew $14 billion from India. If the same were to happen this year - net FIIs investments in shares in 2011 is currently close to zero - the RBI would have to pay up.

In short, it is more than likely that the RBI is conserving its assets for a worst-case scenario as in 2008-09, when it had to sell $44 billion to smoothen the currency market. Also remember, this time it is worse. It is countries that are collapsing (Greece, Portugal), not just banks and Lehmans.

Against this backdrop, what is the RBI likely to do? Four conclusions emerge.

One, the RBI will intervene only occasionally when intra-day volatility gets too high.

Two, it will not bet against the market and current sentiment. It may have a target at which to intervene, but this target could be well into the 50s against the dollar.

Three, it will take the big dollar buyers - like oil companies - off the market by giving them a direct purchase window. This will ease pressure on the market.

Four, it will open the tap for more foreign exchange loans to be raised abroad. This is already happening.

The RBI is wary of using its ammo too soon in the war against global risk-aversion.