The rupee is now a big market. Summing across both spot and derivatives, perhaps $30 billion a day of onshore trading and $40 billion of offshore trading takes place. Both these markets are tightly linked by arbitrage. In other words, for all practical purposes, it’s like NSE and BSE which are a single market unified by arbitrage. If you place a small order to buy 100 shares on either NSE or BSE, you get essentially the same price, and arbitrageurs are constantly at work equalising the price across both markets. It is a similar state of affairs between the onshore and the offshore rupee. Both markets are tightly integrated by arbitrage.
The offshore market for the rupee, and a large part of the onshore market, is OTC trading. Hence, the efficiencies of algorithmic trading and algorithmic arbitrage cannot be brought to bear on onshore/offshore arbitrage. So the arbitrage is done by manual labour. Still, it gets done. Both markets are tightly linked and show the same price. We should think of them as one market. It’s one big market, it is one of the big currencies of the world, it’s roughly $70 billion.
q: How might RBI do manipulation of this market?
If RBI wants to hit the market with orders big enough to make a difference, they have to be ready to do fairly big orders and to be able to do it on a sustained basis. As a rough thumb-rule, I might say that in order to make a material difference to a market with daily volume of $70 billion, they have to be in the market with atleast $2 to $3 billion a day.
q: What would go wrong if they tried this?
Three things would go wrong.
First, foreign exchange reserves are $275 billion. If RBI sells off $2.75 billion a day, the reserves would be quickly gone.
Second, when RBI sells dollars and buys rupees, this sucks liquidity out of the market. The side effect of selling dollars would be a sharp rise in domestic interest rates. In other words, monetary policy would get hijacked by currency policy. This would not be wise. Monetary policy should be focused on delivering low and stable inflation: it should have no ulterior motives.
Third, suppose you and I saw a fake market price of Rs.45 per dollar, which is created by RBI and not a market reality. We would know that in time, the truth will out, that the price will go back to Rs.52 a dollar. The rational trading strategy for each of us would be: To sell any domestic assets, and to shift money out of the country. This would trigger off an asset price collapse in India. We would take the money out, and wait for RBI to give up on these adventures. At that point (perhaps Rs.52 a dollar, perhaps worse) we would bring the money back to India and buy back our assets. We might make two returns here: first, on the move of the INR/USD from 45 to 52 (or worse) and on the drop in asset prices.
q: Isn’t it hard to take money out of India in this fashion?
It’s easier than we think. Remember September 2008? The mythology in our heads was: India is crouching safely behind a wall of capital controls. In truth, the wall wasn’t there.
q: But until recently, Mother RBI used to give us a pegged INR/USD exchange rate! What changed?
In late 2003, RBI ran out of bonds for sterilisation. Associated with that, there was a first structural break in the rupee exchange rate regime, with a doubling of volatility. A short while later, in March 2007, there was another doubling of volatility. From April 2009 onwards, RBI’s trading in the market has gone to roughly zero. Mother RBI stopped managing the exchange rate a while ago.
The exchange rate is the most important price of the economy. The decontrol of this exchange rate is the biggest achievement of the UPA in economic reforms. The credit for this goes to Y. V. Reddy and Rakesh Mohan (who took the first two steps of doubling exchange rate flexibility) and to Dr. Subbarao (who got out of trading on the currency market, which did remarkably little to INR/USD volatility).
q: Why did nobody tell me that something changed in the exchange rate regime?
RBI should be talking more transparently about what is going on. But they are not transparent about what they do. Even though hundreds of millions of people are affected by their trading on the currency market (or the lack thereof), the manual which governs their currency trading at any point in time (i.e., the documentation of the prevailing exchange rate regime) is not transparently disclosed to the people of India. We have to decipher what is going on by statistically analysing exchange rate data.
q: So what might happen to the rupee next? Is there a `law of gravity’ which will pull it back to erstwhile values of Rs.45 or Rs.50?
When you don’t manipulate a financial market, the price time-series comes out to something close to a random walk. In the ideal random walk, all changes are permanent. The random walk never forgets; there is no law of gravity which takes it back to recent values. Your best estimator of what it will be tomorrow is: what you see today.
In order to get a sense of what will come next, go through the following steps. First, go to INR/USD options trading at NSE, and pluck out the implied volatility for the four at-the-money options. I just did that, and the values are: 10.43, 10.32, 10.33 and 10.08. Calculate the average of these. With the above four values, the average is: 10.3. (This is a quick and dirty method; here is one which is much better).
This tells a very important thing: The options market believes that in the future, the volatility of the INR/USD rate will be 10.3 per cent per year.
In order to re-express this as uncertainty per month, we divide by sqrt(12). This gives the volatility for a month as : 3% per month.
Roughly speaking, the 95% confidence interval for what might happen over a month, then, runs from -6% to +6% (this is twice the standard deviation, which we just worked out was 3% per month).
The INR/USD is now Rs.51.62. By the above calculation, we can be 95% certain that one month from today, it will lie somewhere between 48.5 and 54.7.
These trivial calculations have been done by equity market participants for the longest time. It is a standard and trivial idea: To read the implied volatility off the Nifty options market, and to do such calculations to get a sense of what might come next with Nifty. But on the currency market, this is relatively novel. Only recently have we got a nice currency options market, and only recently have we got to a genuine market. Now these skills can be brought to bear on the currency market.
q: What changed in imports and exports which gave us the big recent move of the rupee?
The current account (goods, services, and then some) adds up to a mere buying and selling of $4 billion a day. The bulk of currency trading is about the capital account. The currency is a financial object; the exchange rate is defined by financial considerations and not by current account considerations.
q: What happens to the Indian economy when the rupee depreciates?
This has been the source of a great deal of confusion and it’s important to think straight about this. There are exactly three important effects in play:
- Some people had borrowed in dollars, and left is unhedged since they were speculating that the INR would appreciate. They have got burned. That’s okay – in a market economy, many people place bets about future fluctuations of financial prices, and half the time the speculator loses money. (If the rupee had not depreciated sharply, these speculators would have been truly joyous).
- When the rupee depreciates, imports become costlier and India’s exports become more competitive. So exports (X) gradually start going up and imports (M) gradually start going down. The net gain in X-M is increased demand in the local economy. In this fashion, INR depreciation is good for aggregate demand (and conversely INR appreciation pulls back demand). However, we have to bear in mind that these effects are small and take place with long lags.
- Many things in India are tradeable. It is important to focus on the things that are tradeable and not imported. As an example, there are many transactions between a domestic producer of steel and a domestic buyer of steel. Both buyer and seller are in India. But the price at which they transact is the world price of steel (which is quoted in dollars) multiplied by the INR/USD exchange rate. Through this, the domestic prices of tradeables go up when the rupee depreciates.