The recent rupee-dollar fluctuations have spooked the markets.
How far could the rupee fall ? A look at the simplest models.
Money market players can take vacations. Equity investors have long weekends. Not forex traders, though. When it comes to forex, everyone except the sadhus at the Kumbh mela are always invested. It does not matter whether you play the market actively, or if your national currency is not fully convertible. Every time your currency fluctuates, the value of your savings change.
So, its not surprising that daily volumes in forex markets are huge - close to $2000 billion - some 200 times as much as Wall Street. This is the biggest and the most classically free market in the world. All the players are institutional and even the US Federal Reserve or the German Bundesbank or the RBI are merely players and not referees - volumes are too large to be manipulated.
The international markets are unregulated. If someone is willing to buy and someone else willing to sell, the deal happens. The hard currencies have markets where people sell upto 10 years forward. Some currencies like the rupee have only shallow six-month forward markets. A vast majority of deals are speculative where fully convertible currencies are concerned, but semi-convertibles like the rupee tend to register more trade-related deals.
Economists have worked overtime to study forex fluctuations and identify their underlying causes. Many models have been created, vast acres of rainforest have been pulped to print erudite papers, even a couple of Nobels have been awarded, but no theory has yet been completely accepted.
In that context, the diversity of opinion about the current rupee/greenback equation is not surprising. Especially since there are entrenched commercial interests whose bottomlines and future strategies depend heavily on the rupees direction. Not to speak of politicians with positions to defend.
Some feel the rupee must be held down in order to maintain Indian export competitiveness. Others, including most FIIs, feel the rupee is overvalued anyway and should decline at least 6-10 per cent by year-end, perhaps moving back to its historic low of Rs 38.20 versus the dollar. The odd pessimist is talking about the rupee hitting 40.
That may be an psychological overreaction set off by the South Asian meltdown. The Baht in particular has devalued some 25 per cent in the last month and almost every Asian currency has been hit. Its not just Orientals, the Business Week trade-weighted dollar index has moved over 10 per cent in the greenbacks favour in the last year.
On the other hand, India has a significantly lower current account deficit than the more export-oriented South Asian economies which have been hit. Hence, it may not be vulnerable to copycat meltdowns. Some analysts however subscribe to a paranoid theory that the rupee is actually being artificially depreciated to maintain export competitiveness, and it would rise if the RBI withdraws from the market.
The RBI official position seems to be that the rupee is broadly in the right position vis-a-vis the dollar. According to PM Gujral in an infamous interview, it should continue to be held within a price band close to the current spot rate. The RBI qualified that statement hastily but did not exactly deny it.
This isnt just a theoretical argument. Japan and South Korea built their export competitiveness on weak currencies. If the rupee declines, exporters and FDI investors gain, while importers and Foreign Portfolio investors get mauled. If it appreciates, exporters lose their competitiveness while portfolio investors and importers gain from the translation.
While everyone and his kid sister has strong opinions on the subject, nobody has publicly gone through the basic exercise of plugging numbers into some standard forex equation models and seeing whether distortions are apparent. That is the object of this exercise.
While no single theory is completely accepted, the vast majority of traders use similar basic models to make valuations. They tend to ignore macro-economic factors such as the trade balance, money supply and their possible long term impacts, coming down to strictly quantifiable factors such as differences in interest, spot, and forward rates.
The most popular model which is known as the four way equivalence model has been highlighted in the box. The FWE models benchmarks forex rates. It highlights distortions and possible arbitrage positions. It combines the theory of expectations with the theories of interest rate and purchasing power parity. It also illustrates the Fischer effect linking interest rate parity with rational inflation expectations and the International Fischer effect linking interest rate parity with expected spot prices.
The basic interest rate parity concept is the key. It holds strongly across most freely traded currencies. The rupee is certainly freely tradeable on the trade account, even if it isnt fully convertible. There should not be huge distortions.
To judge interest rate parity, a banker calculates a basic deal called a Covered Interest arbitrage. Can he borrow a low-interest rate currency and exchange it for one with a higher interest rate, reconverting back to the original currency with significant gain ? The first conversion is at the current spot rate. The second conversion is using forward rates. If the deal nets close to zero, interest rate parity exists, there is no arbitrage opportunity and the current exchange rate is stable.
If there is an obvious distortion, arbitrage will force the exchange rate closer to equilibrium. A more risky variation called Uncovered interest Arbitrage is reconversion using spot rates. There, the player takes a risk on the spot rate moving sharply. Till recently, FIIs in India could not take forward cover at all. Exporters and banks could however take forward cover. Now FIIs can take cover on the money market and debt, though they still cannot hedge equity exposure.
In the real world, equibrilium rarely prevails exactly. But, a stable currency rate should produce results close to equality for all legs of the FWE. Wide divergences from equivalence signals large fluctuations. Of course, certain assumptions must be made in assuming interest rates. Here the prime lending rate had been taken as the benchmark. The current dollar -rupee interest rate difference is 6 per cent assuming 8.5 as the US prime lending rate and 14.5 as the Indian term rate.
In the last two years, apart from a squall in February 1996, when the rupee plummetted to Rs 38.20 versus the dollar, things had been generally stable. For over a year the rupee was sitting around a narrow band of approximately Rs 35.70. Only last week, it started to move down again.
We discover that the rupee was indeed overvalued from the interest parity angle at its July price of Rs 35.80 with a six month forward rate of Rs 36.40. At those levels, the banker would have fetched $ 105.19 lending in India, which more than offsets his US payout of $104.25. To reach equilibrium from that point, a six-month spot rate of Rs 36.72 would have been expected. So the rupee would have expected to drop, as it indeed did.
But the forward market may be over correcting. Now, the spot rate is at Rs 36.38 while one month forward rate has climbed to Rs 36.60, and the six month rate is at Rs 37.71 reflecting the current trend of devaluation. The implication is that the rupee spot rate is expected to devalue by around that much in the next six months. The one-month premium annualises to 7.21 per cent while the six month premium is at 7.05 per cent.
A minor distortion that - possibly created by momentary supply-demand factors. But, doing the covered interest arbitrage at current rates we discover that the pendulum has indeed swung the other way. If a banker converted $100 at the current spot rate of Rs 36.38 and lent it for six months at 14.5 he would receive Rs 3901.75. Reconverting at the current six-month forward rate of Rs 37.71 he would then have $ 103.47 which is less than the $104.25 he would have to pay at the US prime rate of 8.5. It would now make sense to borrow rupees and lend dollars - if that were possible.
Assuming interest rates are not changing drastically, the forward rate thus definitely overvalues the dollar. Equilibrium could be reached at a spot rate around Rs 37.42 to a dollar in six months time. This means that forward premiums must come down.
Thus the interest rate parity model indeed establishes that there are arbitrage positions available and the exchange rate is thus due to fluctuate further, assuming interest rates dont change drastically. If the interest rate gap narrows, the whole equivalence changes. Indian rates are dropping and US rates are rising, but not at a pace where this disparity would be neutralised quickly. The (discount) premium using prime lending rates is currently around (minus) 5.24 per cent.
We can thus expect two things. Since the interest parity models for July-August 1997 levels, predict equilibrium in a band between Rs 36.72 and Rs 37.42 in the five-six months, we can expect the rupee to decline further. However, since there is also currently a reverse arbitrage position available, six month forward rates must see the rupee strengthen. So the market will have to live with the likelihood of a further devaluation but it will not be as drastic as people expect.
We are ignoring the fourth leg of the equation because purchasing power parity is a rather theoretical concept which does not have much effect in the short run. Anyway, it isnt the primary concern of a trader, exporter, or foreign investor. But given the chance of the rupee falling further, the FII cutbacks in the equity markets make imminent sense.
Even spectacular rupee-denominated equity performance will see gains being wiped out by devaluation. Since December 1996, the Sensex has gained 36.8 per cent in $ terms anyhow, so they may as well take profits and cut risks. While the FII will pullback, export performance will go up sharply - so could FDI inflows. Once the rupee stabilises at more sustainable levels, the FIIs will come back.
