As this article is written on the morning of September 12, 2018, one US dollar is quoting at 72.85 Indian rupees. This is the lowest the rupee has fallen against the US dollar.
News reports suggest that the government has asked the Reserve Bank of India (RBI), the central bank, to intervene aggressively in the foreign-exchange market to support the value of the rupee.
This is hardly surprising, given that in the last few years in India, the value of the rupee against the dollar has become an issue of national prestige and has been extensively used for political brinkmanship.
It’s not as if the RBI has not intervened up until now to hold up the value of the rupee. As of end of March, the total forex reserves of the RBI stood at $424 billion. By August, they had fallen to $400 billion.
This tells us that the RBI has clearly been intervening in the forex market. It has been selling dollars and buying rupees to protect the value of the Indian currency. But despite this intervention, the value of the rupee has continued to fall against the dollar. In early April, one dollar was worth around 65.1 rupees.
All the RBI intervention has done, perhaps, is to slow down the fall in the value of the rupee and made it less volatile. The question is, to what extent should the RBI go to defend the value of the rupee?
To answer that question precisely, we need to dive into the past. As of March 2009, the total investment by foreign portfolio investors in the Indian debt market stood at a minuscule 21.38 billion rupees. In later years, the Indian debt market started to open up for foreign investors. Something else happened as well.
In September 2008, Lehman Brothers, the fourth-largest investment bank on Wall Street, went bust. This led to a financial crisis in the Western world, with economic growth falling dramatically. The Western central banks, led by the Federal Reserve of the United States, started to print money to drive down interest rates, to encourage consumption and investment, all in the hope of reviving their respective economies.
The idea was that people would borrow and spend and companies would borrow and expand. But it did not play out like the central bankers had hoped for. The people had already done their share of borrowing in the run-up to the financial crisis.
What happened instead was that big institutional investors borrowed money at low interest rates and invested in stock and debt markets all over the world. A lot of this money came into the Indian stock market. Between April 1, 2009, and March 31, 2018, foreign portfolio investors invested 6,623 billion rupees ($91 billion) in the Indian stock market, at a net level.
This is well known. What isn’t so well known is that a lot of money came into the Indian debt market as well. With interest rates in the West close to zero, it offered a very good arbitrage opportunity to foreign portfolio investors.
Between April 2009 and March 2018, foreign portfolio investors brought a total of 3,929 billion rupees into the Indian debt market.
A lot of this money came in primarily because money was easily available at low interest rates in the West. Now this might be in the process of changing.
The US Federal Reserve has gradually started to withdraw all the money it had printed and pumped into the financial system, in the hope of reviving the economy. As this money is withdrawn, interest rates are likely to go up. As rates go up, the strategy of borrowing cheap in the West and investing in India will not really work.
In this scenario, money is bound to leave India. In fact, it already is. Since April this year, foreign institutional investors have withdrawn 428 billion rupees, or nearly 11% of the money they brought into India’s debt market between April 2009 and March 2018.
There is no upper limit to the total amount of money that can be withdrawn by foreign institutional investors from India’s debt market, primarily because unlike stocks, the returns here are limited.
In this scenario, the RBI is dependent on the policies of the US Federal Reserve. If the Fed continues to suck out all the printed money, interest rates in the United States and other parts of the Western world are bound to rise. This could lead to any amount of money leaving India’s debt market.
Trying to defend the rupee in such a scenario will be a bad idea. It has been seen in the past that when a country gets obsessed with defending the value of its currency, its stock of foreign-exchange reserves can run out very fast. A central bank only has so many dollars, and unlike the Fed, it can’t create them from thin air.
Also, sometimes too much intervention by the central bank and the government is taken as a panic reaction, and foreign institutional investors sell out sooner rather than later. India saw this happening between May and August 2013.
Nevertheless, many central banks, including the RBI, operate in a democracy, and letting a currency fall to its natural value is not something that they can always do.
Gasoline and diesel prices in India are already at a very high level because of the rupee losing value against the dollar. And India’s middle class isn’t happy about it. The government is not in a position to cut taxes and drive down prices of motor fuel.
Businesspeople who borrowed in dollars wanting to make use of low interest rates, and then did not hedge their borrowing, are already trying to influence the agenda.
In this scenario, it remains to be seen for how long the RBI can hold on without intervening aggressively in the foreign-exchange market.
As Duvvuri Subbarao, former governor of the RBI, writes in his book Who Moved My Interest Rate?:
“Let me conclude my experiences of steering the rupee in turbulent waters by reiterating a standard dilemma. Given my position that a sharp correction of the exchange rate was programmed and forex intervention by the Reserve Bank would only postpone the inevitable, wouldn’t it have been rational to just stay put till the adjustment had been complete? Sensible maybe, but virtually impossible in the shrill democracies of today.”
To conclude, another RBI governor made a similar point to me when he said that in a “moment of crisis the central bank can’t be seen to be doing nothing,” even if “do nothing” might be the best strategy.