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Thursday, December 01, 2011

The rupee: Frequently asked questions

q: How big is the market for the rupee?

The rupee is now a big market. Summing across both spot and derivatives, perhaps \$30 billion a day of onshore trading and \$40 billion of offshore trading takes place. Both these markets are tightly linked by arbitrage. In other words, for all practical purposes, it's like NSE and BSE which are a single market unified by arbitrage. If you place a small order to buy 100 shares on either NSE or BSE, you get essentially the same price, and arbitrageurs are constantly at work equalising the price across both markets. It is a similar state of affairs between the onshore and the offshore rupee. Both markets are tightly integrated by arbitrage.

The offshore market for the rupee, and a large part of the onshore market, is OTC trading. Hence, the efficiencies of algorithmic trading and algorithmic arbitrage cannot be brought to bear on onshore/offshore arbitrage. So the arbitrage is done by manual labour. Still, it gets done. Both markets are tightly linked and show the same price. We should think of them as one market. It's one big market, it is one of the big currencies of the world, it's roughly \$70 billion a day.

q: How might RBI do manipulation of this market?

If RBI wants to hit the market with orders big enough to make a difference, they have to be ready to do fairly big orders and to be able to do it on a sustained basis. As a rough thumb-rule, I might say that in order to make a material difference to a market with daily volume of \$70 billion, they have to be in the market with atleast \$2 to \$3 billion a day.

q: What would go wrong if they tried this?

Three things would go wrong.

First, foreign exchange reserves are \$275 billion. If RBI sells off \$2.75 billion a day, the reserves would be quickly gone.

Second, when RBI sells dollars and buys rupees, this sucks liquidity out of the market. The side effect of selling dollars would be a sharp rise in domestic interest rates. In other words, monetary policy would get hijacked by currency policy. This would not be wise. Monetary policy should be focused on delivering low and stable inflation: it should have no ulterior motives. We have to make a choice: Do we want to use up the power of monetary policy to achieve domestic goals, or do we want to use up the power of monetary policy to achieve currency policy goals?

Third, suppose you and I saw a market price of Rs.45 per dollar, which is created by RBI and not a market reality. We would know that in time, the truth will out, that the price will go back to Rs.52 a dollar. The rational trading strategy for each of us would be: To sell any and every domestic asset, and shift money out of the country. This would trigger off an asset price collapse in India. We would take the money out, and wait for the distortion of the currency market to end. At that point (perhaps Rs.52 a dollar, perhaps worse) we would bring the money back to India and buy back our assets. We might make two returns here: first, on the move of the INR/USD from 45 to 52 (or worse) and the second, on the gain from the drop in asset prices.

q: Isn't it hard to take money out of India in this fashion?

It's easier than we think. Remember September 2008? The mythology in our heads was: we in India are crouching safely behind a wall of capital controls. In truth, the wall wasn't there.

q: But until recently, RBI used to give us a pegged INR/USD exchange rate! What changed?

In late 2003, RBI ran out of bonds for sterilisation. Associated with that, there was a first structural break in the rupee exchange rate regime, with a doubling of volatility. A short while later, in March 2007, there was another structural break, with another doubling of volatility. From April 2009 onwards, RBI's trading in the market has gone to roughly zero. RBI stopped managing the exchange rate a while ago.

The exchange rate is the most important price of the economy. The decontrol of this exchange rate is the biggest achievement of the UPA in economic reforms. The credit for this goes to Y. V. Reddy and Rakesh Mohan (who took the first two steps of doubling exchange rate flexibility twice) and to Dr. Subbarao (who got out of trading on the currency market, which did remarkably little to INR/USD volatility).

q: Why did nobody tell me that something changed in the exchange rate regime?

RBI should be talking more transparently about what is going on. But they are not transparent about what they do. Even though hundreds of millions of people are affected by their trading on the currency market (or the lack thereof), the manual which governs their currency trading at any point in time (i.e., the documentation of the prevailing exchange rate regime) is not transparently disclosed to the people of India. We have to decipher what is going on by statistically analysing exchange rate data.

The dates of structural break of the exchange rate regime are extremely important dates in thinking about what was going on in macroeconomics and international finance. Any time one is using data about exchange rates, interest rates, etc., it is important to work within one segment of the prevailing exchange rate regime at a time. It is wrong to pool data across many years. All users of data need to be careful in this regard.

q: So what might happen to the rupee next? Is there a `law of gravity' which will pull it back to erstwhile values of Rs.45 or Rs.50?

When you don't manipulate a financial market, the price time-series comes out to something close to a random walk. In the ideal random walk, all changes are permanent. The random walk never forgets; there is no law of gravity which takes it back to recent values. Your best estimator of what it will be tomorrow is: what you see today.

In order to get a sense of what will come next, go through the following steps. First, go to INR/USD options trading at NSE, and pluck out the implied volatility for the four at-the-money options. I just did that, and the values are: 10.43, 10.32, 10.33 and 10.08. Calculate the average of these four numbers. With the above four values, the average is: 10.3. (This is a quick and dirty method; here is one which is much better).

This tells a very important thing: The options market believes that in the future, the volatility of the INR/USD rate will be 10.3 per cent per year.

In order to re-express this as uncertainty per month, we divide by sqrt(12). This gives the volatility for a month as : 3% per month.

Roughly speaking, the 95% confidence interval for what might happen over a month, then, runs from -6% to +6% (this is twice the standard deviation, which we just worked out was 3% per month).

The INR/USD is now Rs.51.62. By the above calculation, we can be 95% certain that one month from today, it will lie somewhere between 48.5 and 54.7.

These trivial calculations have been done by equity market participants for the longest time. It is a standard and trivial idea: To read the implied volatility off the Nifty options market, and to do such calculations to get a sense of what might come next with Nifty. But on the currency market, this is relatively novel. Only recently have we got a nice currency options market, and only recently have we got to a genuine market. Now these skills can be brought to bear on the currency market. It's a brave new world, one in which the operations of financial derivatives markets (Nifty options, INR/USD options) produces forward-looking and timely information about the economy (implied volatility).

q: What changed in imports and exports which gave us the big recent move of the rupee?

The current account (goods, services, and then some) adds up to a mere buying and selling of \$4 billion a day. The bulk of currency trading is about the capital account. The currency is a financial object; the exchange rate is defined by financial considerations and not by current account considerations.

q: What happens to the Indian economy when the rupee depreciates?

This has been the source of a great deal of confusion and it's important to think straight about this. There are three important effects in play:
  1. Some people had borrowed in dollars, and left it unhedged since they were speculating that the INR would appreciate. They have got burned. That's okay - in a market economy, many people place bets about future fluctuations of financial prices, and half the time the speculator loses money. (If the rupee had not depreciated sharply, these speculators would have been truly joyous).
  2. When the rupee depreciates, imports become costlier and India's exports become more competitive. So exports (X) gradually start going up and imports (M) gradually start going down. The net gain in X-M is increased demand in the local economy. In this fashion, INR depreciation is good for aggregate demand (and conversely INR appreciation pulls back demand). However, we have to bear in mind that these effects are small and take place with long lags.
  3. Many things in India are tradeable. It is important to focus on the things that are tradeable and not just on the things that are imported. As an example, there are many transactions between a domestic producer of steel and a domestic buyer of steel. The buyer and seller are both in India. But the price at which they transact is the world price of steel (which is quoted in dollars) multiplied by the INR/USD exchange rate. This situation is called `import parity pricing'. Through this, the domestic prices of tradeables goes up when the rupee depreciates.

q: What is the impact of costlier tradeables for RBI?

RBI's job is to fight inflation. RBI must work to deliver year-on-year CPI inflation (a.k.a. `headline inflation') of four to five per cent. When tradeables become costlier, domestic CPI inflation goes up. So the rupee depreciation has made RBI's job harder. RBI will have to respond by hiking interest rates. (Note that one impact of higher interest rates will be that more capital will come into India, which will tend to yield a rupee appreciation; import parity pricing has created a new channel through which RBI rate hikes combat inflation).

q: What is the impact of costlier tradeables for business cycle conditions in India?

As the example above about steel suggests, the price realisation of all tradeables companies goes up when the rupee depreciates. Costs change by less by revenues (since many costs are not tradeables), and profitability goes up.

Firm profitability has dropped sharply in 2011. My prediction is that firms producing tradeables will show better profitability in Oct-Nov-Dec 2011 when compared with the previous quarter, thanks to the rupee depreciation.

This is great news for business cycle conditions. Profitability goes up, which yields more cash for investment by financially constrained firms. And, when profitability is higher, more investment projects look viable.

q: In the bottom line, what is the link between the rupee and India's business cycle stabilisation?

If RBI tried to peg the exchange rate, the lever of monetary policy would get used up to deliver the target exchange rate. By not trading on the currency market, the lever of monetary policy is now available. A pretty good use for this lever is to deliver low and stable CPI inflation. If this is done, then an RBI focused on inflation would help stabilise the economy by cutting rates when CPI inflation drops below 4% and hiking rates when CPI inflation goes above 5%.

But floating the exchange rate also yields stabilisation purely in and of itself. In bad times, capital leaves India, the rupee depreciates. This gives higher profitability in tradeables firms and bolsters investment. Conversely, when times are good, more capital comes into India, the INR appreciates, which crimps profitability of tradeables firms. The floating exchange rate exerts a stabilising influence upon the economy: purely by doing nothing on the currency market, RBI has unleashed this new force of stabilisation which will help India.

q: What should RBI do next?

RBI should do as they have done, i.e. avoided trading on the currency market.

RBI should keep driving up the short-term interest rate until point-on-point seasonally adjusted CPI inflation shows a decline and goes into the target zone of 4-5 per cent. After this hangs in there for a year, `headline inflation' (y-o-y growth of CPI) will be in the target zone.

q: What do other countries do?

When we look at countries with good governance, the mainstream strategy seen worldwide is an open capital account and a central bank that delivers on an inflation target. By and large, this goes with a floating exchange rate. Trading on the currency market interferes with achieving price stability and has hence been dispensed with, by most good countries. Japan and Switzerland come to mind as exceptions to this broad regularity.


  1. Very good piece of blog on Rupee. Thanks for the time you have taken to write this. Those who shout from roof tops that heavens have fallen down due to rupee depreciation should read this compulsorily.


  2. Hi,

    I am a bit skepticl about using USDINR implied vols. Given the high correlation between the Index and INR, isnt there a feedback loop.


  3. Hi
    Great post to help understand about current rupee situation.

    I am a little confused over this part in the post:

    "The current account adds up to a mere buying and selling of $4 billion a day. The bulk of currency trading is about the capital account. The currency is a financial object; the exchange rate is defined by financial considerations and not by current account considerations."

    When I see the RBI data on BOP -

    the current account and capital/ financial account numbers (in terms of exports and imports) are not that different. So how is bulk of the currency trading about the capital account?

    I am sure I am missing something here, can you please help?

  4. Dear Rajat,

    Not all gross turnover on the currency market shows up in the BOP. I'm not fully competent on how BOP is done, but this is a global phenomenon: We see lots of trading on the currency market, all of which (strictly speaking) should show up in the BOP, but it does not.

    The rough numbers for the market size today are: $30 billion a day onshore and $40 billion offshore. None of what happens offshore shows up in BOP data (it is USD cash settled). Similarly, exchange-traded currency derivatives in India do not show up in the BOP (they are INR cash settled). Even after one subtracts out these two, the rough numbers in my mind do not square with the rough numbers in the BOP. In short, I think it's an interesting question and worth exploring and fully understanding.

  5. Interesting article. Particularly the point about increased stability due to decontrolling Rupee. Typo: "Random Walk never forgets" -- probably you mean "random walk never remembers".

    1. Random walk never forgets.

    2. Under the random walk, all changes are permanent. The best forecast of tomorrow is: What the price is today.

      If prices were NOT a random walk, then changes are temporary and tend to get erased. The system tends to go back to where it was. The best predictor of the future is not where it is today, but where it had been.

  6. Your excellent contributions make me perspire to catch up!

    While I have to struggle to digest the Contents of your Contribution and that of Professor Susan Thomas' Paper (cited by you), I have an enquiry first:

    If you were to take more Data for at-the money-options and apply Professor Thomas Method, what would be the result of 95% Confidence Limit?

    I am very embarassed, in fact, I must do these Calculations: it is unfortunate, I am not academically good enough to do this onerous task: hence, a request for your erudite comments, if the results by the two methods differ significantly.

    Best regards

    Poolla R.K. Murti

  7. Hi

    The BOP break-up is given in the same link - in an excel -

    The major items are FDI, FII and ECB figures. I have tried to verify the FII investments with data on SEBI website and the numbers are very similar.

    So, current and capital accounts at max contribute to about $ 8 bn per day of total currency market, out of total 70 bn market.

    So, I can conclude that roughly 88% of the currency market is determined by trading activities (short term speculation) rather than by fundamental forces of supply and demand for rupee. That also makes any short term volatility meaningless and eventually the exchange rate should converge to long term fundamentals.

    A probable implication of this is also that RBI should not enter into the market just based on short term volatility.

  8. With reference to Rajat Gupta, I wish to present my views on:

    "That also makes any short term volatility meaningless and eventually the exchange rate should converge to long term fundamentals"

    Long-term fundamentals is the Pet Phrase in theoretical Economics !
    Fundamentals are what we cite them out to be - like Inflation rate differentials, BOP surplus/deficits, Interest-rate differentials, investment flows into and out of the Country (after REGAN took over in 1981, it is Investment flows into the US that proppped up the $ vs the DM, as per the ECONOMIST magazine that time), not to speak of, rational (or is it irrational?) expectations of the Market Participants etc. I may be forgiven if I make an unfashionable Comment that there are nothing like Fundamentals or even if excellent Economists establish them through (albeit time-wise and space-wise very limited!) empirical studies, the Fundamentals only remain a notion and not to be taken as proved facts!) I wish to know, based on what fundamentals the $-DM Exchange rate was fixed after the Second World War?

    Milton Friedman eloquently and elegently argued for a Floating Exchane Rate Syatems (presumably based on Fundamentals) but being an Academic was unfortunately not aware of Market-sharks like George Soros who would make the Markets dance to their Tunes! Fundamentals will take over a Long period of time after the Market-sharks exit with their legally-earned booty !

    It seems Mathiar Mohammed wanted to shoot George Soros (who was comfortably dining in Hotel Hilton in New York!) during the 1996-97 collapse of the Malaysian Ringget!

    The observations of Rajat Gupta are commendable from an Academic View Point:My layman's view point is, a good scope for this situation is our opening up the Forward & Derivitavive Trading in our Rs FX-market (I am ashamed I do not have any empirical-study support,as of date, to validate this purely-qualitative observation of mine: I am perhaps imitating the great Galbraith!)

    As an Academic, I very much commend Rajat Gupta and his Research into Reserve Bank Data: I wish to be benefited by his scholarly observations on the mundane issues raised by me.

    With Best regards to Rajat Gupta

    Poolla R.K. Murti

  9. great article, but the point ignored is that of illogical market momentum, which can transfer havoc from financial economy to real economy. concerted attack on a country's currency ( not unheard of in currency markets), for speculative gains can easily end up hurting economy in long term as well, specially during an inflationary phase. the dramatic fall of rupee in the last 4 months( perhaps highest amongst currencies of major economies) can not point to normal market response to macroeconomic factors. more vigilance from rbi will not be unwarranted.

  10. hi ajay sir,
    i am novice but my question is roughly $500 million only is the FII outgo as for as the stock market is concerned.You say around $7 billion transaction in a day in currency $500 million(month) to $70billion (day) is nothing.But how could Rupee losing from 47 to almost 52.If we make currency futures delivery based is it possible if so will have any effect

  11. Hello Ajay Sir/Mr. Rajat ,

    When we say 8 billion , then we meqan total net turnover in USD terms is 8 billion i.e. say I bought 1 billion and then sold the same 1 billion , then total turnover = 2 billion in the capital account .

    The same holds for current account. If I buy services for 1 billion and sell services for another 1 billion , total current account transaction becomes 2 billion for the day ...

  12. indian economy like many emerging economy was a beneficiary of cheap money since 2002 and indians thought that they have entered a new era...the crash in indian economy will take place via rupee crashing to 75 vis a vis dollar in short order...
    the leverage the indian IT enjoyed for some time is also fast disappearing as many jobs are being outsourced to vietnam, phillippines and even bangladesh...

    60-75% of the indian foreign reserves are owned by outsiders and can quickly flee...And indian RE is poised for a monumental crash as well...50% of FII money in india come from euro zone that is delevergaing w/ vengeance...
    India will face the dark forces of liberalization as they been enjoying the positive side for about 20 yrs// but the dark forces often undo good work of a decade in a jiffy..

  13. Dear Ajay,

    What does the rupee depreciation mean in the big picture?
    Is it fluctuating because of speculation and is it as serious as The Asian crisis or the one inflicted by Soros in the past?

    Or is the India growth story a temporary phenomenon just
    happened because of easy money available between 2002 and 2008?

    Will the Indian rupee crash to 75 as feared by Anonymous?

    Appreciate if you can talk about big picture. thanks

  14. Great insight to Re-USD. Thanks Ajay. I think it's always better let the market determine the rate rather than pegging.

  15. Dear Rajat/Ajay/Rahul,
    On BOP and transactions in currency market. The BOP counts transactions by residency, so a transaction between two residents in a foreign asset (say, USD) would not be shown in BOP (it would be counted in the year/period in which the resident first acquired the asset from a non-resident), unless these transactions are accompanied by counterpart foreign currency transactions with the non-resident banks of these parties. The same for a transaction by two foreigners in an Indian asset. Only cross-residency transactions are counted.
    However, these transactions lead to changes in international investment position (changes in the external assets/liabilities of the sectors involved) and are counted there.

    I am sure there are other factors leading to the discrepancy, but this is one.

  16. excellent..idiot question..when u talk about critical dates of structural break in exchange rate policy, are u talking of:

    i) 2003 Budget

    ii) March 2007

    iii) april 2009

    that u refer to midway in your blog?

    jaggi malkani

    1. I am talking about dates of structural change in the exchange rate regime as identified by the Zeileis/Shah/Patnaik methodology.

  17. Hi Ajay,

    Its nice to see the complete details of Rupee vs USD and how RBI cannot do anything in these circumstances. Nice write-up.

  18. Sir, I really appreciated the comprehensive handling of INR scenario. It gave me a lot of food for thought. Just a few points for clarification.

    If intervention in currency market forces interest rates upwards.. that's also contributing to a decrease in inflation. In that sense, it should not hurt India to intervene in the currency market when required.
    Also, when RBI is increasing the rates in the domestic market that should also serve as a pointer for foreign investors to invest in India to gain from higher interest rates. That would automatically take care of currency appreciation.
    It could work both ways round. Why it's not working means only one thing. Foreign investors don't want to take any additional risks and they see India as a risky place as of now.

    Secondly, I don't think INR appreciation only affects topline. It has started affecting the bottomline as well in terms of the energy costs which are a major input for manufacturers. So I think that the outlook is bleaker than you think in the short term. What India needs right now is currency appreciation. That RBI can't guarantee it is understood and means that India will have to wait for more sound policy decisions to reduce the riskiness of its economic environment. Moreover, RBI can at least refrain from making statements that we don't have sufficient reserves to tackle currency markets. That only prompts the financial predators to get harsher. A little push can get dangerous.

    Having said all that, I do think situation is not going to get any worse :)

  19. "Second, when RBI sells dollars and buys rupees, this sucks liquidity out of the market. The side effect of selling dollars would be a sharp rise in domestic interest rates."

    What does RBI do with the INR that it gets by selling dollars?

    1. RBI has a balance sheet where liabilities are the total number of rupees issued. Against this it has certain assets which are Indian government bonds, US government bonds, etc.

      As in any balance sheet, the assets and liabilities must equal.

      When RBI sells dollars, it gets rupees which are taken out of circulation. The assets and liabilities of RBI both go down. This is a monetary tightening.


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