Have you ever been caught on a stormy sea? It’s hard to commit yourself to a certain bearing when you don’t even know where you are. Wait for the storm to subside, take a reading on your current location, and then plot your new bearing to get back on course.
The Central Bank of India may be doing precisely that, refusing to intervene to stop the Indian rupee from being tossed around like a helpless ship caught in the tempest currently ravaging the currency markets.
Beginning from just over 44 rupees per $1 U.S. at the end of July 2011, India’s currency has lost half its value as it just this morning hit its all-time low, almost touching 66 rupees per U.S. dollar. In the last four months since May 1st, the rupee has had some 22% (12 rupees) sheared off its value, while losing some 12% (7 rupees) in the last four weeks since July 26th.
India’s is not the only currency drifting aimlessly on the churning seas of money exchanges since May 1st, as almost every other nation’s money sinks against the USD. But while most other nations are busy hiking interest rates to stabilize their currencies and selling bonds to reduce and strengthen their money supply, India is opting to do nothing.
What in the world could it be thinking? Should other nations follow course?
Currency Markets in Flux
With the start of U.S. monetary stimulus five years ago, money had been flooding into foreign markets, especially developing or emerging economies. As interest rates fell in the U.S., they rose overseas. And as injections of cash into the American economy put the USD under pressure, foreign currencies began appreciating. Not only were investments in emerging economies enjoying income growth through high bond interest, they were also enjoying capital growth from foreign currency appreciation.
But everything changed May 1st when U.S. Federal Reserve chairman Bernanke announced the FOMC’s desire to bring its monthly bond buying program to a close within a year. This triggered an evacuation of funds not just out of the American bond market, but out of foreign bond markets and their currencies as well, since systematic reductions to U.S. stimulus over the course of a year would strengthen the USD and weaken foreign money as measured against it.
This put emerging markets in a tight spot, since most carry budget deficits and require a steady stream of foreign deposits to keep them afloat. As N.R. Bhanumurthy, professor at the National Institute of Public Finance and Policy in New Delhi, explained to USA Today,
“Most of these economies have a high current account deficit. Foreign investors look for returns and rewards on the risk they undertake and the majority opinion for now is that returns on U.S. bonds are higher than returns on emerging market bonds.”
In an effort to stop the withdrawal of those sorely needed deposits, emerging economy central banks began raising interest rates, lifting the value of their currencies to make them more attractive to investors.
India Bucks the Trend
For a while, even India played along, pulling all the standard strings to strengthen the rupee. One string is to raise the interest rate, which the Central Bank of India did last month.
Another way to strengthen a currency is to reduce its quantity circulating through the economy; the less there is of something, the higher its value. The CBI reduced the money supply in three ways: selling bonds (which takes cash out of the economy and replaces it with certificates), increasing the cash reserve requirements of banks (which keeps money locked in bank vaults), and capping cash injections of stimulus into the Indian banking system.
But earlier this month, the CBI suddenly stopped fighting the storm. It is now going to let its currency float where it will, giving rise to a rash of criticism.
Paul Hoffmeister, a senior analyst for Bretton Woods Research LLC in Mount Tabor, NJ, wrote in a note obtained by Forbes, “They should be selling bonds to extinguish excess rupees, but the RBI [Reserve Bank of India] is not doing so.”
Hoffmeister is also calling for more forward guidance from India’s central bank to keep the markets calm. “To keep the rupee’s value within a stable band against the dollar, the RBI needs to manage the supply and demand for rupees by communicating its intentions to keep the rupee stable,” he stressed. You’d be amazed what a monthly “pep-talk” from officials can do to calm a market’s jitters.
Don’t Rock the Boat
But the Indian government sees things as just temporarily out of kilter, and it doesn’t want to do anything drastic that could potentially make things worse later on.
Brian Jackson, a global currency strategist at Coutts, a London-based wealth management firm, wrote in a research paper obtained by USA Today “that it is hard to see the Reserve Bank being able to control the rupee’s fall without further impeding growth, either by pushing up bond yields or making it more difficult to access bank financing.”
Remember those strings central banks usually pull to strengthen their currencies mentioned above? The trouble with those is that they also slow economic growth, as higher interest rates suck more money out of businesses through interest on their debts, which trickles through the economy as jobs are cut and wages fall.
Hence, the Indian government is not “drawing a red line on where the rupee should be,” expressed Deputy Chairman of the Planning Commission, Montek Singh Ahluwalia, in a televised interview as transcripted by Forbes. “At the moment,” he views, “the rupee is over depreciated.”
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And that is the Indian government’s view as well – that the rupee’s recent depreciation is just the result of over-active trading and posturing ahead of the expected U.S. Fed’s stimulus tapering announcement.
Professor Bhanumurthy agrees that this is simply “short-term volatility backed by foreign capital outflow,” he opined to USA Today. “My guess is that it’s speculative outflow, and the market will balance itself out in the next few months, maybe even weeks.”
This is not new, where speculation has strayed currencies way off course in the thick of the turbulence before a calmer atmosphere returns them back to their normal latitudes.
Rough Ride Ahead
Yet where the Indian government and its officials are expecting the rupee to return to normal levels once there is some clearer direction out of the U.S. Federal Reserve come September 18th, others believe the currency is in for a very rough go.
“We now believe that the Indian rupee could touch 70 to the U.S. dollar in a month or so,” Deutsche Bank warned USA Today. “Under a scenario of deep pessimism, currencies can overshoot substantially and remain so for a long time. India, we fear, is entering such a zone.”
Yet it too, like the Indian central bank, believes this should be temporary. “We expect some revival of the currency by the end of the year.”
Investors should be cautious when trading foreign currencies and bonds over the next year. If the U.S. Federal Reserve is to terminate $85 billion worth of monthly bond purchases by the middle of 2014, we might expect reductions averaging $21 billion or so per quarter four times. That is bound to strengthen the USD quite a bit and weaken foreign money all the more.
Where consensus has recently been leaning more toward a December start to tapering rather than September, we may see a brief relief rally in foreign currencies. But this would only prolong the inevitable deflating of emerging market currencies once U.S. bond purchases are finally phased out.
If you really must dabble in foreign markets, ensure your investments are in solid companies with plenty of export revenue, such as from the sales of oil and other resources, autos, airplanes, consumer electronics, and the like. Companies focusing on exports will earn income in currencies other than their own, making revenues more valuable when reported in their weakening local money. Exports thereby reduce a little of the pain of their depreciating currency.
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