subject: Rupee appreciation: Should the RBI act? [print this page] Rupee appreciation: Should the RBI act? Rupee appreciation: Should the RBI act?
The rupee strengthened to its highest level in nearly 2-years on October 14, as FIIs continue to flood in Indian markets. The rupee touched Rs 44.19 versus the USD, amidst buying frenzy by overseas investors. Foreign funds have bought a record USD 21 billion of Indian equities so far this year, one-third of which has flown in since the start of September. Consequently, banks and exporters continue to sell dollar in local markets so as to track gains in local shares.
Why this dollar deluge?
In search of higher yields' western bound funds have made a beeline for emerging markets like India, where the return is far more. The interest rate differential between, say in US and a country like India is significant' and is ever-expanding (while interest rates in US are at nadir, one cannot thump the desk and say that emerging markets are done with rate hikes as they continue to fight inflation and hike rates). Together with better growth prospects, these differentials have generated capital flows to countries with higher rates and increased the attractiveness of carry trades (see graph). Besides, it is beneficial for FIIs as well, at the time FIIs repatriate their money, as they have to part with a lesser amount of rupee when they convert it to USD.
The carry-to-risk ratio is a popular ex ante measure of the attractiveness of carry trades. It adjusts the interest rate differential by the risk of future exchange rate movements, where this risk is proxied by the expected volatility (implied by foreign exchange options) of the relevant currency pair. Rupee appreciates, will the government or RBI blink? Probably not, yet. The Finance Minister has made it clear that at this juncture there is no need to cap FII inflow and he may be right considering the following:- 1. Q1 FY11 CAD figures came on a higher side. The USD 13 billion Current Account Deficit was more than three times, what was in the corresponding quarter of the Q1FY10. The annualized figure for USD 55 billion for FY11 is surely a near to medium term risk and considering India received has USD 20 billion in H1 2010-11, the flows appear well within the absorptive capacity. 2. The rupee appreciation has also helped RBI and the government to suppress the imported part' of the inflation. Though in doing so, the RBI has to bear some criticism from the exporter community, the RBI and the government has to choose between the lesser of two evils! 3. The government has in its arsenal, what we call sterilization', which basically is buying back the excess rupee' by issuing securities, which it released when it sold dollar. In doing so the government can actually stem the rupee appreciation. However, the process has its own costs' attached to it. Sterilization won't make much sense and will only add to the burden on RBI and the government, as issuing securities would entail heavy interest outgo.
