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Monday, October 12, 2009

Interpreting recent movements of the rupee-dollar rate

In recent weeks, there has been a lot of focus on the appreciation of the rupee against the dollar. In an opinion piece in Financial Express today, I point out that the US dollar has fluctuated considerably in the period after September 2008, and interpret the recent events on the Indian currency market. At first, in the `flight to safety' into US government bonds that came about after the Lehman shock, the US dollar gained ground. As the global financial system has gained confidence, the reversal of this `flight to safety' has meant a concomitant decline in the US dollar.

These ups and downs of the US dollar have important implications for our intuition in India about the rupee-dollar rate. If we think the US dollar is roughly fixed, then the pursuit of an inflexible rupee-dollar rate can be interpreted as some kind of `stability'. But if the US dollar itself is a fluctuating yardstick, it is hard to justify efforts at RBI to obtain inflexibility of the rupee-dollar rate. When the dollar declines in value, an attempt at holding on to a rigid rupee-dollar rate is tantamount to forcing a rupee depreciation, and vice versa.

Greater flexibility in the rupee dollar rate will free up monetary policy to pursue the more important goal of stabilising the domestic business cycle. But along the way, for firms to learn to live with greater flexibility of the rupee dollar rate, well functioning currency derivatives markets are required. RBI needs to first step away from the present strategy of banning most of these markets, so as to be able to move forward to greater flexibility of the rupee.

On the macroeconomic arguments about the long-term decline of the US dollar, see Wolfgang Munchau in the Financial Times today.


  1. i guess the dollars is kept weak since the democrats want to win the midterm election coming in 2010. obama wants to push lots of reforms and therefore wants to show that manufacturing is back by keeping the dollar weak

  2. Dear Mr Ajay
    I invite your view on $/Rs Rate, going fwd. As USD appreciated sharply in last 6 months 18% agst Eur and 21% agst GBP, whereas agst INR it depriciated only 10% (mostly recently in Oct'09), do you feel INR is set to appreciate in future on the same line.
    Fundamentally, Rs movement are guided primarily by FII flows & RBI actions, In FY 2009-10 FIIs inflows are much more than projected at start of FY, in recent times RBI is also silent as Rs is appreciating quite late compared to other Asian counterparts.
    Your views on INR movement with a time horizon of 12-18 months are invited.

  3. I am sorry, erroneously mentioned "As USD appreciated sharply in last 6 months 18% agst Eur and 21% agst GBP, whereas agst INR it depriciated only 10% ............. ", which I mean

    "As USD depriciated sharply in last 6 months (since march'09 low levels) appx 18% agst Eur and 21% agst GBP, whereas agst INR it depriciated only 10% (mostly recently in Oct'09), do you feel INR is set to appreciate in future on the same line. "

    I regret inconv, pl.

  4. Ajay,does not RBI already use REER~1. You are making it sound like its all Rupee-Dollar while that may not be the case? Some other economists have lauded RBI for being 'different' this time and adopting a hands off approach when FIIs were withdrawing capital and Rupee was depreciating.Why does RBI love Dollar-Rupee tango?

    The most important item that can take off some of RBI's anxiety at domestic economy's stability is decontrol of oil sector. If the
    recent hush talk on moving away from dollar pricing for Oil materialises,the weightage that RBI
    attaches to Dollar may reduce.

  5. Quite a confusing post, Ajay. On the one hand you say that the RBI should not peg to the dollar because not only is the latter a moving target but pegging hems in domestic monetary policy. Fair enough. But if the rupee is going up, surely that means that the RBI has not followed up with downward pressure on the currency? So either they are already following your advice or you are launching some kind of preemptive salvo to try and dissuade them from pushing the rupee down. Which is it?

    Either way, your point about market development is well taken. The deeper issue though is whether or not such a market would have a hope of being deep and liquid enough to perform the risk-sharing functions that you envision for it.

    There is a natural hierarchy of global currencies that derives from the size of the respective economies. India is not a key currency, nor is it likely to be in the near future. For your market-development argument to really hold, you have to cite an instance of the development of a deep and liquid currency market in a non-key currency.

    You will find no such thing because of the structure of the global currency market, which in turn is derived from the structure of the world economy. So while market development might be necessary for the kind of risk-dispersal that you envision, it is far from sufficient.

    This is because there is a structural deficit on one side of this future market: fewer players want to take on emerging market risk than there are those wanting to get rid of such risk, by definition. Emerging markets account for a mere 10 percent of global currency market turnover, according to the BIS. Such lopsidedness militates against efficient risk-distribution through a market. Hence the need for the RBI to socialize currency risk.

    To be sure, the RBI can be overzealous in so doing, but that is an argument over price rather than principle. The principle at stake here is whether there can be an efficient currency market in a non-key currency of an emerging market.

    This is a question that I've seen you address. It appears important because if the answer is "no," your entire argument would be in jeopardy. I'm sure your many readers would be keen to have an answer. I know I am :)

  6. Ajay, the basic premise of your article itself is probably wrong.As the following annexures in RBI's annual report indicate,RBI's policy is to peg against a basket of currencies and not US Dollar.And REER against the basket of 6 currencies has ranged from 112 in April '08 to 96 in June '09.

    The wider 36 country based REER has ranged from 101 to 91 in the same period.The reason for a wider
    divergance in the latter case can be the rapid clip at which our trade has grown and rendering the
    composition fit for change.Time to revise the composition once again,perhaps.
    Even in 2005,Euro's weightage was 35 compared to US's 28 and now that China is our largest trading partner,one wonders why Dollar's importance is exaggerated not only at RBI but in policy debates as well.Why Dollar was chosen for currency futures and not, say, Euro or Yuan?

    This document from RBI's 12th October Bulletin show that as per provisional data, REER for 6 currency basket has remained near ~100 for current financial year till September 18th per base year 1994-95.
    But,importantly, as per base year 2007-08 REER has been near 88 reflecting a huge subsidy to Indian exports. Now that green shoots are here,RBI has allowed Rupee to appreciate.
    What is missed in the REER weights are India's huge Software exports and remittances which now are more than 50% of merchandise exports.

  8. Central banks are a bit notorious for not doing as they say.

    It is one thing for RBI to say they focus on REER; it is entirely another for them to actually do this.

    There is a rich literature on identification and classification of the de facto exchange rate regime - that which is the facts on the ground, as opposed to the claims being made. For Indian evidence, see: India's currency regime and its consequences by Ila Patnaik (2007), which appeared in EPW, and : The difficulties of the Chinese and Indian exchange rate regimes which appeared in European Journal of Comparative Economics.


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