Jamal Mecklai: Back to the pavilion

Like love, sentiment is an intangible and can't really be measured. Its impact, however, is profound; when aroused, sentiment can completely overturn your life, or, more prosaically, financial markets."

Elegant words, even if I say so myself, and as true today as they were when I first wrote them two years ago.

At that time, I had developed a model to measure the cost of negative sentiment by comparing the actual value of the rupee with the one that would have prevailed if it had simply followed the dollar index (DXY). Subsequently, I modified the model to build in inflation differentials (creating a real effective exchange rate-type model) and voila!

The new model tracked the rupee almost perfectly (average tracking error of 1.2 per cent) from September 2011 to January 2013.

From then on, however, things started to fall apart - unsurprisingly, for that's the nature of models. Under a modest surge of inflows in early 2013, the rupee stayed firm, even as the dollar strengthened globally. The inflation differential, of course, continued to take singles every ball, widening the gap with the model, and by May, without anyone really noticing, the target run rate had fallen sharply, with the rupee nearly seven per cent stronger than it should have been.

 

And then, the US Federal Reserve - or was it Yusuf Pathan - hit out, announcing the start of tapering. Everything fell out of bed. The rupee was amongst the worst hit, falling hysterically, ending up 15 per cent behind the model by early September. Overvaluation never sustains.

Emergency action by the government and Reserve Bank of India (RBI) Governor Raghuram Rajan as the new captain of the cricket team brought a little control and the rupee clawed some of the losses back, but the market still remained way ahead in terms of the target rate. Things continued to improve, though, and by early March, when elections were announced, the home team got a real flush of hope in a long time and it was able to push the run rate further down.

Finally, on May 16, with a few key wickets, the rupee rallied over 59 and the target began to look realistic for the first time since June 2013. It seems that India (and the rupee) is back on track. But there's no time for complacency - the market is already taking fresh guard. The team is waiting in the dressing room for the Budget. While improved sentiment is expected to generate another surge in the rupee, the steady drip, drip, drip - it's raining - of the inflation differential keeps the pressure on. Under the Duckworth-Lewis method, the run chase target could get pushed to 60.75 by the end of September and 61.50 by the end of December.

During the run chase (post-Budget), the rupee would doubtless open steady and, perhaps, even strengthen somewhat. The increasing confidence will pooh-pooh the Duckworth-Lewis target, and the run rate may stay subdued for some time - remember, the market can stay irrational a lot longer than you can stay solvent. But overvaluation (and overconfidence) never works forever. Morne Morkel may be brought on or Dale Steyn could rediscover himself, which could trigger another dramatic giveback, as we have seen so many times in the past.

Clearly, the captain has his work cut out for him. During the first inning, he needs to keep things tight. Given that liquidity is very comfortable - the RBI conducted its first four-day term reverse repo a day before the policy announcement on June 2 - the governor should actually increase the cash reserve ratio. In other words, bring Harbhajan Singh on. This would make it easier to continue, and possibly accelerate, its intervention in the foreign exchange market (and keep the target in view) without the threat of increasing inflationary pressures as a result of the rupees pushed into the market.

For the run chase, the captain needs to ensure his players have all the strength they need. His big hitters - the infrastructure companies - need the freedom to swap high-cost rupee loans into dollar ones and hedge these with spreads, providing a very good risk/cost-saving profile. The RBI needs to lift the "derivative on a derivative" constraint as early as possible - it's been debated endlessly for years. The smaller boys - the bit players who are frequently the ones ultimately chasing down the runs - need the flexibility to manage their positions with call and put spreads - the RBI should immediately remove the restriction on small companies using these critical instruments. So, captain, keep the bowling tight, deregulate steadily and continuously and, importantly, work with the team management to address structural issues - increase the boundaries to 90 metres, for instance - to make the game more manageable.

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jamal@mecklai.com