The Rupee Sutra: Quick to fall, slow to regain ground

The rupee’s fall to below 50 to the US dollar on Friday has given rise to predictable, and entirely justifiable, hand-wringing. A weaker rupee will compound the ‘imported inflation’ effect and generally be a dampener that leaves us feeling poorer.

Yet, it’s worth bearing in mind that the weakening rupee pattern of recent weeks is a familiar one, which has come about in a specific context of general global risk aversion - and a flight to safety to the US dollar in anticipation of a heightening of the eurozone crisis.

The pattern mimics almost to perfection the rupee-dollar rate graph in the weeks leading up to the 2008 financial crisis, when the rupee (and indeed all emerging market currencies) fell like a rock against the US dollar. Between August and October 2008, the rupee went from 42.6 to 51.5 against the US dollar, a dizzying plunge far more pronounced than the one we’ve seen in recent weeks.

In March 2009, the rupee bottomed out at 51.79 to the dollar, and recovered gradually to 44.3 in April 2010. Since then, it was bound in a range, until - beginning August - it went into a free fall over heightened Eurozone fears.

And although there are several peripheral reasons to account for the weaker rupee of recent weeks, bear in mind that the downside effect has been exaggerated by the risk aversion building up in markets, and a stampeding into the US dollar.

Today, every conceivable market - from equities to debt to currencies - is quaking in fear ahead of the upcoming eurozone summit and wondering what lies in store. Given the low-visibility ahead, investors have sought refuge in the US dollar.

How long will the weakness last?

That depends on how the eurozone crisis unfolds. In the absence of a sufficiently “big deal” at the European summit to tackle the solvency issues that grip peripheral eurozone states, the uncertainty will drag on, dragging down all emerging market currencies, including the rupee.

But even in the event that the markets are calmed by a sufficiently big expansion of the eurozone bailout fund, and the flow of bailouts to Greece, the pace at which the rupee, and indeed all emerging market currencies, gain strength is unlikely to be frenetic.

When they fall, emerging market currencies fall like a rock. But their recovery more closely resembles the slow crawl of a mountain climber.

The effect can be explained by what economists - and physicists - call the “ hysteresis effect ”. This effect is used more often to explain trends in the labour market and in export performance, but can also be invoked in game theory models.

Simply put, this is the effect where the impact of a given shock does not work the same way in the opposite direction when the shock is reversed.

Secondly, in the foreign exchange market, there is also a policy bias among central banks that, in a crisis, pushes currencies down faster than they appreciate once the crisis passes.

During periods of excessive capital outflows, most central banks in emerging markets prefer to allow currencies to depreciate rather than allow their reserves to fall. But when capital flows reverses and start pouring in again, policymakers typically tend to accumulate reserves so as to limit currency appreciation.

This is exactly what we saw from 2008 to 2010: a sharp fall, and a slow climb back up. This time too, depending on how severe the eurozone crisis gets and how long the agony is prolonged, we’ll likely see an accentuation of the fall of the rupee of recent days, followed by a very gradual retracing of the ground that it would have lost.