The rupee begins to slip

The change of guard at the RBI occurs at a time when Indian foreign exchange markets, which had stood their ground during the South-East Asian currency crisis, are exhibiting intense volatility.

C.P. CHANDRASEKHAR

THE change of guard at India's central bank could not have occurred at a more inopportune time. As Planning Commission Member-Secretary Bimal Jalan's expected move to Mumbai to replace C. Rangarajan as Reserve Bank of India Governor was being announced, India's foreign exchange markets, which had stood their ground during the South-East Asian currency crisis, turned nervous. On the first day of November, the selling price of the rupee, which fluctuated within an extremely narrow band during the last week of October, stood at 35.68 to the dollar. Relative to July 1, the rupee had depreciated by less than 2 per cent vis-a-vis the dollar, as compared with 60 per cent in the case of the Thai baht.

However, by the middle of November, a slow fall starting in the first week of the month gave way to intense intra-day volatility and significant day-to-day declines. By November 11, the selling price had slipped almost consistently to 36.64, though the fall was periodically tempered through intervention by the RBI to sell dollars and stall sharp intra-day declines. Thus on November 11, the RBI reportedly delivered between $250-350 million to halt a steep intra-day decline. The next significant fall occurred six days later, on November 17, when the rupee touched a 21-month low of Rs.36.89. Opening at 36.74, it dropped to 36.77 when the SBI entered the market for dollars. Intervention by the central bank did not prevent a further fall to 36.89. By this time the rupee had lost 122 paise relative to the dollar compared to November 1. The next day, November 18, the rupee dropped by 58 paise to touch a new low of 37.52 before rising again in the wake of RBI intervention, to close at 37.4. The 58-paise fall within a single day was the second largest fall since India entered the liberalised unified exchange rate regime on March 1, 1993. The largest was a 68 paise fall on September 10, 1995.

Examining the November trend as a whole points to two features: first, an almost consistent decline in the value of the rupee equal to 172 paise or around 4.8 per cent vis-a-vis the dollar; secondly, clear signs of an acceleration of that fall in recent days, with the decline having touched 1.8 per cent on a single day on November 18. These features of the situation are significant because of the context in which they occur. It is widely accepted that the large depreciations of the currencies of India's South-East Asian competitors would have eroded any price advantages that it had in world markets. Such an erosion of competitiveness occurs at a time when, despite an industrial recession, India's imports have been rising faster than its exports, which have turned sluggish. And, within India's liberalised trade regime, the only policy corrective to a worsening trade balance available to the Government is a depreciation of the rupee, which even under the liberalised exchange rate system, can be manipulated through central bank intervention.

Not surprisingly, the Government has been keen to talk the rupee down. Unfortunately, a recent experience indicated that when the rupee is encouraged to depreciate, it could be subjected to a speculative attack that sets off a steep decline that can have devastating consequences. Being a currency that is not yet fully convertible, the rupee cannot be subjected to speculative attacks of the intensity that the South-East Asian currencies were victims of.

HOWEVER, there are many ways in which the speculative run can operate. Exporters can postpone the repatriation of export proceeds. Overseas buyers can postpone placing orders to benefit from lower dollar prices. Importers with foreign exchange accounts can hoard dollars to meet imminent foreign exchange payments. Foreign investors can hold back on investments to benefit from the fall in the value of the rupee when it occurs. The FIIs can sell out their shareholdings for fear of losing in dollar terms if the sale is postponed. And non-residents holding foreign currency accounts can repatriate their investments for fear that a collapse of the currency can result in a change in laws, even if temporarily. The available evidence suggests that all of these are happening in some measure. The most visible impact is on the markets for GDRs issued by Indian corporates, the slackness in which has resulted in the postponement of all or part of such issues by a number of leading corporates like GAIL. If speculation in this form triggers a sharp slide in the rupee, it can have repercussions for the real economy that can be quite damaging, as the East Asian experience shows.

The Government's dilemma with regard to how to deal with the rupee in the liberalised environment is discernible in contrary statements by different arms of the state. While the Commerce Ministry, troubled by the sluggishness in exports, attempts to talk down the rupee, the RBI, through intervention and repeated statements by its Governor, constantly cautions the market against believing that the rupee's decline will be sharp and significant.

Such contradictions arise because of the fact that financial and exchange rate liberalisation has meant that the value of the rupee is no more linked closely with trade fundamentals. Much of the rupee's behaviour in the last few years has been influenced by capital account movements. Periods characterised by large capital account inflows have seen a strengthening of the rupee, moderated only by the RBI's willingness to purchase and hold dollars in its reserves, which have burgeoned to more than $30 billion. Periods of investor uncertainty, triggered either by developments in India or in other emerging markets, have set off a decline of the dollar, which then is subject to the danger of a free fall driven by speculative movements. Hence the RBI has to step in by selling dollars to stall such a slide.

SEEN in this light, the current signs of volatility are not due to any immediate disastrous weakening of India's current account. While trade fundamentals are slightly worse than in the immediate past, the real danger is investor belief that depreciation elsewhere in the world will force a Government that has liberalised imports substantially to allow the rupee to depreciate substantially. This belief is not without some basis, since the Government has virtually given up most other ways of controlling the trade deficit. But that belief adversely affects both capital account flows as well as certain flows on the current account, such as export realisations, which behave in a manner similar to capital account flows. The pressure this puts on the rupee makes the RBI's effort at a controlled depreciation an extremely difficult, if not near-impossible, task.

Thus far the RBI has executed this task partly through periodic intervention of magnitudes that are small ($250-500 million) relative to its reserves and principally through efforts to talk up the rupee by cautioning speculators of the possibility of more intense intervention whenever the rupee tends to slide too far. For example, when on November 18, the rupee depreciated by 58 paise, C.Rangarajan issued a statement in which he said inter alia: "Despite the turbulence in the foreign currency markets in East Asia, the Indian rupee remained stable both in September and October 1997. India's fundamentals, particularly in relation to the external sector, continue to remain strong. While the Reserve Bank of India has been ensuring that there is no undue volatility and that there are orderly conditions in the market, the rupee has been adjusting to the changing circumstances. We believe that the adjustment that has already taken place in the value of the rupee is adequate. In view of the fundamentals, there isno ground for a further weakening of the rupee. RBI will not hesitate to intervene to prevent any overshooting."

The references to East Asia and trade fundamentals reflect the fears of the RBI. The statement on intervention is a veiled threat to the speculator that he is likely to lose if he moves out of the rupee. But if this does not quell speculation now or later, intervention would have to be of a magnitude that is significant relative to existing foreign reserves. This would reduce its reserves and weaken the only basis on which the RBI's threats are respected by the market, if they are at all. If that happens, financial liberalisation would have extracted, in India, the price that has been paid by the East Asians. Unfortunately for Dr. Jalan, the incoming RBI Governor, it is he who will have to deal with such a situation.