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Economy Dec 3, 2011

The RBI should forget forex rates and focus on inflation

By Ajay Shah

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 side-effect of selling dollars would be a sharp rise in domestic interest rates.Reuters

The offshore market for the rupee, and a large part of the onshore market, is OTC (over-the-counter) 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 the RBI manipulate 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 volumes 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 fake 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, the RBI used to give us a pegged INR/USD exchange rate! What changed?

In late 2003, the 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, the RBI's trading in the market has gone to roughly zero. The 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 YV 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?

The 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 thinking 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 percent 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 percent.

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

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

Continues on the next page..

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by Ajay Shah

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