Arbit Raj

Email alarm made government close arbitrage window“, screams the headline in this morning’s Business Standard. Upon reading further, you will find that the said “arbitrage” opportunity in question consists of remitting rupees abroad now and then bringing it back as remittances once the rupee has depreciated further. There are so many things wrong with this approach that I can hardly get started.

1. Technically speaking, arbitrage refers to a situation where through a set of trades one can make riskless profit. The riskless point is important here. If I were to convert my rupees to dollars today and then convert the dollars back to rupees later, it would be arbitrage if and only if the price at which I would sell the dollars is guaranteed (as of today) to be higher than the price at which I buy dollars. If I buy dollars today in the hope that the rupee will depreciate, it is NOT arbitrage.

2. By calling this process “arbitrage” the government is admitting that the rupee is expected to drop further, and significantly in the coming months (the extent of capital controls being imposed now suggests this). This is bad signaling

3. Regulating arbitrageurs is futile, and can be counterproductive. Arbitrageurs are quick to spot any price inconsistencies in the market and ruthlessly exploit them by means of their trades. Thus, if it is expected that (say) the USDINR will trade at 65 tomorrow, it is arbitrageurs who make sure that this expectation is reflected in today’s price (through a set of spot-future currency trades). By trying to curtail the operations of arbitrageurs, the government is missing out on valuable price signals. In other words, they are beheading the messenger (a la the Khwarizmian Shah, and everyone knows what happened to his empire once he did that).

The measures the government has been taking in recent times to help prevent further depreciation of the rupee are so ad hoc and badly thought out that it would make eminent sense to call the current dispensation an “arbit raj”.

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.

Source: V Anantha Nageswaran
Source: V Anantha Nageswaran


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.