Butchered rupee: What FM should have learned from housing, dotcom bubbles

It is important to remember that just because a negative event hasn't happened in the recent past, that doesn't mean it will never happen in the time to come. In India, currently there is a great belief that real estate prices will continue to go up forever. Is that the next 'big' turkey waiting to be slaughtered?

Vivek Kaul August 02, 2013 11:46:18 IST
Butchered rupee: What FM should have learned from housing, dotcom bubbles

"The rupee depreciation of June, July was quite unexpected," said finance minister P Chidambaram on August 1, 2013.

What does Chidambaram mean here? He probably means that the government was caught unaware on the depreciation of the rupee against the dollar over the last two months. They were not prepared for it.And if the government had realised that the rupee would lose value against the dollar as fast as it has, then it would have done a few things to control it, like it is trying to do now.

When one looks at the economic reasons behind the rupee's fall against the dollar they were as valid then, as they are now. The current account deficit for the period of 12 months ending March 31, 2013, had stood at 4.8% of the GDP or $87.8 billion. The current account deficit is the difference between total value of imports and the sum of the total value of its exports and net foreign remittances.

During the period of twelve months ending December 31, 2012, the current account deficit of India had stood at $93 billion. In absolute terms this was only second to the United States.

Amay Hattangadi and Swanand Kelkar of Morgan Stanley Investment Management point out in a report titled Don't Take Your Eye of the Ball "At $93 billion, India's current account deficit in 2012 was second only to the US in absolute terms, and higher than the UK, Canada and France."

A high current account deficit meant that India's demand for dollars to pay for imports should have been higher than the supply. The dollars that India earned through exports and the dollars that were being remitted into India were not enough to pay for the imports.

Hence, this meant that the rupee should have lost value against the dollar. But that did not happen because foreign investors kept bringing dollars into to invest in stocks and bonds in India. At the same time Indian corporates were borrowing in dollars abroad and kept bringing that money back to India. The Non Resident Indians were also bringing dollars into India and converting them into rupees to invest in bank deposits in India because interest rates on offer in India were higher.

All this effectively ensured that there was a good supply of dollars. This in turn meant that the rupee did not lose value against the dollar, even though the current account deficit had gone through the roof.

Butchered rupee What FM should have learned from housing dotcom bubbles

So why did Chidambaram find the rapid depreciation of the rupee against the dollar "unexpected"?

But a high current account deficit should have been warning enough for the government that rupee could snap against the dollar, at any point of time. The dollars coming in through foreign investors in bonds and stocks and NRIs deposits, could go back at any point of time. Also, money being borrowed by the Indian companies in dollars, would have to be repaid. And this would add to the demand for dollars.

Hence, steps should have been taken to control the high current account deficit by controlling imports. And at the same time steps should have been taken to ensure that dollars kept flowing into India. The government got active on this front only after the rupee started to lose value against the dollar since the end of May, 2013.

But why did the government and the finance minister not figure out what sounds a tad obvious with the benefit of hindsight? As I have explained here, here, here,here and here, most of the factors that have led to the rupee depreciating against the dollar, did not appear overnight. They have been work-in-process for a while now.

So why did Chidambaram find the rapid depreciation of the rupee against the dollar "unexpected"?

The basic reason for this is the fact that between January and May rupee moved against the dollar in the range of 54-55. It was only towards the end of May that the rupee started rapidly losing value against the dollar.

Chidambaram and others who had thought that the rupee will continue to hold strong against the dollar had become of what Nassim Nicholas Taleb calls the turkey problem. As Taleb writes in his latest book Anti Fragile "A turkey is fed for a thousand days by a butcher; every day confirms to its staff of analysts that butchers love turkeys "with increased statistical confidence." The butcher will keep feeding the turkey until a few days before thanksgiving. Then comes that day when it is really not a very good idea to be a turkey. So, with the butcher surprising it, the turkey will have a revision of belief-right when its confidence in the statement that the butcher loves turkeys is maximal ... the key here is such a surprise will be a Black Swan event; but just for the turkey, not for the butcher."

Chidambaram expected the trend 'of a stable rupee' to continue. What was true for the first five months of the year was expected to be true for the remaining part of the year as well. But sadly things did not turn out like that, and the rupee like Taleb's turkey got butchered.

By May end, foreign investors were falling over one another to withdraw money from the Indian bond market. When they sold out on bonds, they were paid in rupees. Once they started converting these rupees into dollars, the demand for dollars went up. As a result the rupee rapidly lost value against the dollar, and only then did the government wake up.

As Taleb writes "We can also see from the turkey story the mother of all harmful mistakes: mistaking absence of evidence (of harm) for evidence of absence, a mistake that tends to prevail in intellectual circles."

Just because something is not happening at the present time, people tend to assume that it will never happen. Or as Taleb puts it, an absence of evidence becomes an evidence of absence. Chidambaram was a victim of this as well.

There is a bigger lesson to learn here. People expect any trend to continue ad infinitum. For example, before the financial crisis broke out in late 2008, Americans expected that housing prices will keep increasing for the years to come. In a survey of home buyers carried out in Los Angeles in 2005, the prevailing belief was that prices will keep growing at the rate of 22% every year over the next 10 years. This meant that a house which cost a million dollars in 2005 would cost around $7.3million by 2015. This faith came from the fact that housing prices had not fallen in the recent past and everyone expected that trend to continue.

The same phenomenon was visible during the dotcom bubble of the 1990s. Every one expected the prices of dotcom companies which barely made any profits, to keep increasing forever. The great investor Warren Buffett stayed away from dotcom stocks and was written off for a while when the prices of dotcom stocks rose at a much faster pace than the value of investments that he had made. But we all know who had the last laugh in the end.

The Japanese stock market and real estate bubble of the 1980s was also expected to continue forever. A similar thing has happened with gold investors this year. Just because gold prices had rallied for more than 10 years at a stretch, investors assumed that the rally will continue even in 2013. But it did not.

Hence, it is important to remember that just because a negative event hasn't happened in the recent past, that doesn't mean it will never happen in the time to come. In India, currently there is a great belief that real estate prices will continue to go up forever. Is that the next 'big' turkey waiting to be slaughtered?

(Vivek Kaul is a writer. He tweets @kaul_vivek)

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