foreign exchange – Pertinent Observations

Rupee against emerging market currencies

One common argument by experts who claim that there is nothing to be worried about the decline and fall of the Indian Rupee in recent times is that the Indian Rupee is not the only currency that is falling, and that other emerging market currencies are also falling equally badly. In order to test this out, we will look at the movement of the rupee as a function of other so-called “emerging market” currencies.

I’m just going to offer the graphs here (of movements of various currencies against the rupee) without any comment. All graphs are of the form “how many units of foreign currency does it take to buy a rupee”. So the higher this graph, the higher the level of the rupee compared to this particular foreign currency. And it is on purpose that I’ve drawn all charts starting from Jan 1st 2008, so that the US financial crisis is also captured.

Data for all charts is taken from oanda and charted using quantmod for R.

More on USD/INR

Via email, V Anantha Nageswaran gave a simple theory on the USD/INR exchange rate. Posting it here with his permission.

Using the above chart, which charts the exchange rate over the last 20 years, he says:

The chart attached is quite clear. Except for the period between 2002-07 when actual growth and growth expectations in India shifted higher, the rupee has been on a trend depreciation.

Sustained high inflation (or, rather higher inflation relative to peers) caused by lack of fiscal discipline is the principal or predominant explanatory factor.

To bring back the experience of 2002-07, he states that we need to bring back sustainable growth rates of 7-8%.

Elsewhere, in The Hindu Business Line, S S Tarapore argues that the RBI should not intervene until the USD/INR is at 70. Quoting:

The RBI needs to accept that the rupee is still grossly overvalued despite the decline in recent days. It should not support the rupee till it reaches a rate of around $1 = Rs 70, which would be consistent with the long-term inflation rate differentials between the US and India.

My view is that this may not be enough – this view assumes that Indian businesses (specifically exporters) will be able to take advantage of the falling rupee and export more. This also assumes that domestic demand for petroleum products and gold (our two biggest imports) is elastic and will fall with the falling rupee. If these assumptions don’t come true, things are only going to get worse with a falling rupee.

Also coming back to Ananth’s point on the break in fall of USD-INR in 2002-07, I want to point out that despite our high growth rates in that period, we still didn’t run a current account surplus. It was just that our high growth attracted significant foreign investments which offset our CAD from that period to lead to a rising rupee. The consequent pulling out of those investments has hastened the fall of the rupee over the last few years.

USD/INR Volatility

The stated objective of the Reserve Bank of India when it comes to foreign exchange rates is that they want to maintain a “stable” exchange rate, and will step in only to curb volatility. There is no stated level at which the bank seeks to hold the rupee, and so it will intervene only when the rupee is volatile.

In this post, we will look at how the volatility in the USD/INR exchange rate has varied over the last seven years. For purpose of this analysis, we will use a 30-day Quadratic Variation as a measure of volatility (this is a lagging indicator, so the volatility number for today is the QV of the last 30 days).

The following graph shows both the level of USD/INR (black line, left axis) and the quadratic variation (red line, right axis).

Source: Oanda.com Volatility calculated as 30-day Quadratic variation — Source: Oanda.com
Volatility calculated as 30-day Quadratic variation

Notice that for most time periods, irrespective of the exchange rate, the RBI’s stated objectives have been met – the volatility in the exchange rate has been low for large period of time. Volatility of the exchange rate spiked once following the financial meltdown of late 2008 and again towards the end of 2011 (when Europe got into trouble).

It is interesting to note that for all the footage that the sliding rupee has received in the last month or so, the volatility of the rupee has been quite low (compared to the peaks). It will probably take a significantly higher volatility in the rate for the RBI to step in.

It is also interesting to note that in the second half of 2010, even though the rate level was fairly stable, volatility was significant!