Round number skirmishes

A familiar script plays out regularly with the government fighting rupee depreciation

In India’s currency policy, an odd significance is attached to round numbers. Policymakers resist the market when faced with multiples of 10. The exchange rate is a price determined by the actions of millions of economic agents. But near each round number, the government tries to prevent depreciation, and a familiar script plays out. 

The rupee gets more dwell time near the round number, held up with much huffing and puffing by the authorities. Many distortions are imposed upon the economy. The smart money knows that the market will win. There is ample time in which large speculative positions are built. The costs associated with the rupee defence pile up. Eventually, the government yields ground. The rupee surges past the round number. Speculators break out the champagne. 

How do we assess the macroeconomic fundamentals around the present skirmish? In the domestic economy, the pace of investment is cautious. The current-account balance is the gap between domestic investment and domestic savings. Because domestic investment is weak, the current-account deficit is modest. In India there is no large financing problem that needs to be solved by capital inflows. This situation gives comfort for a strong-rupee policy. 

Global conditions point in a different direction. A problem is brewing in the United States (US) macroeconomic environment because of interest-rate increases. The 10-year rate in the US has risen from 4 per cent in March to 4.7 per cent today. This reflects the possibility that the US Federal Reserve will raise rates further to fight inflation. 

Financial markets operate on relative prices. Capital flows across borders based on the difference in yield and the expected change in currency values. When the US interest rate is higher, Indian assets must become cheaper to justify foreign ownership. An exchange-rate depreciation is the mechanism through which the market economy achieves this equilibrium. 

A lot is made of the Foreign Currency Non-Resident (Bank) war chest. The proposition is that a chunk of foreign money will appear in India, be purchased by the central bank, become ammunition for future currency trading, and postpone rupee depreciation for a few months. The numbers are less impressive than they seem. 

India is now a big country. Gross inflows on the current account are at $1.1 trillion a year. On the capital account, those are $1.7 trillion a year. Put together, we are getting inflows and outflows of about $2.8 trillion a year or about $11 billion a day. A comparison against conditions in the 2013-14 currency defence is instructive. At that time, gross inflows were $0.55 trillion and $0.52 trillion on the current and capital accounts, respectively, i.e. $4.3 billion a day. Today’s India is 2.6 times bigger. 

The FCNR (B) stratagem relies on using public money to defend the rupee. The state subsidises foreign borrowing to attract dollars. This tool requires large-scale borrowing to make a material difference against a gross external flow of $11 billion a day. A commensurately large fiscal cost falls upon the exchequer. The Ministry of Finance will choose how much it is willing to spend in exchange for this round number. 

The size of the economy reshapes the size of speculative pressures. The dollar-rupee market is not limited to financial firms. It involves everyone engaged in international activities. As the next round number approaches, a large array of clever people reshape their ordinary imports, exports, and capital-account activities so as to profit from the depreciation. For example, a family obtaining remittances would hold its breath at ₹96, wait till ₹106, and earn a profit of ₹10 a dollar. Importers will boost their inventories, and exporters will delay bringing their dollar earnings home. Those who can will send money out at ₹96 and turn a profit by bringing it back at ₹106. As the profit opportunity ripens, more ordinary people will take detours to do a little currency speculation on the side. 

With $2.8 trillion of gross inflows a year, a small shift in such leads and lags makes a difference to the dollar/rupee market, which is large when compared with the resources of the authorities. The cost of rupee defence goes up, which increases the odds of policymakers dismantling their barricade at this round number. 

There is important damage outside the immediate fiscal cost. Financial development in India is retarded by hostile policy actions in each round-number skirmish. The Indian state defends the rupee by harming Indian finance. Position limits are reduced. Capital controls are tightened. Regulatory pressure is applied to suppress trading volumes. Liquidity in the onshore currency derivatives market is squeezed. 

These actions increase the cost of doing business in India. Managing currency risk becomes more expensive. When onshore markets are restricted, price discovery shifts to offshore rupee markets in derivatives. The local financial industry loses business and local users find ways to get their orders into the overseas market. The institutional capability of the Indian financial system takes a step backward. Financial-market development — a fundamental input for Indian economic growth — is sacrificed in return for a round number. 

Three factors now point in favour of higher interest rates in India. The first is inflationary pressures in India after the global oil-price increase, which calls for an orthodox inflation-targeting response. The second is the present round number skirmish: Higher interest rates help defend the rupee. The third is higher rates in the US. When the authorities have an exchange-rate objective, there is “exchange-rate dominance”, they obey the US Fed, and they cede their autonomy to pursue the monetary policy that India requires. 

This skirmish will end, as all these skirmishes do. 

It would be good to add one last line in the script. Once the round number is breached, policymakers must reverse all the harm done to financial development during the skirmish.

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The writer is a researcher at XKDR Forum