Monitoring the behaviour of the rupee, relative to the dollar index (DXY), over the past several months provides some insight into RBI’s current FX policy. From October last year to mid-February, the dollar depreciated by about 7%, with the DXY moving from 94.80 to 89.40. Investment flows were strong even though it was clear that US interest rates were to rise. RBI had to stay active, buying and, sometimes, selling dollars to prevent the rupee from responding fully to the dollar’s decline. Over the period the rupee appreciated by just 1.9% (about 1.20 to the dollar), moving from a touch over 65 to a high of 63.80.
The wheel turned in February when oil and the dollar started to climb. The DXY rose steadily reaching 94 by May. Perhaps, finally acknowledging the need for a weaker rupee, RBI allowed virtually all of the dollar’s strength into the domestic market. The DXY appreciated by 5.8% and the rupee fell by an almost identical amount to 67.80. The move was very sharp and RBI had to intervene every day to prevent the decline from turning into a rout. Indeed, the rupee had crossed 68 and was threatening further weakness, till news that Saudi Arabia and Russia had agreed to increase production hit the market late last week, which pulled the rupee back above 68.
The big question, of course, is where do we go from here?
One possibly useful pointer is the chart, which suggests that the intensity of the rupee’s decline, in any case, seemed to be losing steam—each downward clip was arrested earlier than the previous one. Further, the rupee turned up sharply when the oil news came, and the NDF market, which is increasingly becoming the driver of rupee value (certainly at nodal points), immediately marked the rupee up by just 50 paise. It is a further 50 paise higher this morning suggesting, perhaps, that domestic position-taking is being unwound. More power to RBI and, its friend, circumstance.
But, what happens if the DXY, which is still nudging a long-term resistance level around 94, breaks through and shoots up towards 100? Will the RBI retain the near-100% correlation we recently saw when the dollar was strengthening? This would take the rupee north of 70. And, while this number has been thrown around by analysts who somehow “know” what is going to happen, my sense is that RBI would be much more circumspect. Not only would this pressure Indian corporates and banks, a rupee in free-fall would look bad to India’s political masters who are, as always, in campaign mode.
I would bet that any further dollar strength overseas would be met very sternly by RBI—its action last Friday when it jumped in selling dollars after the oil news was more than a warning shot. And, the reaction of the markets suggests that they, too, recognise who’s the boss.
Indeed, RBI’s build-up of reserves, which started under Raghuram Rajan, has served it well. We note that since 2013, the rupee fell as sharply as it did currently twice before—once in 2015 after the taper tantrum and the other time on demonetisation/Trump’s election in 2016.
In both cases, RBI was able to turn the tide quite quickly and the rupee returned to a steady state in a matter of weeks. Prior to 2013, the ` had fallen by 4-5% six times (since 2011), and each time the decline got a lot worse (four times to 10% and once to nearly 15%), before getting better. And, while RBI has used up over $10 bn in this last ` defence, it still has nearly $400 bn of FX assets in hand.
To be sure, India’s macro parameters have deteriorated in recent months (because of oil prices), and the investment environment has worsened (because of higher US interest rates). This suggests that it won’t be as easy for RBI to turn the tide if, in fact, the dollar continues on an upward path —indeed, the drawdown of reserves over the past weeks is the highest since late 2011.
On the other hand, the dollar could turn back from the current resistance, or simply tread water for some time. This could happen, for instance, if US equity investors, particularly given the intrinsic policy uncertainty under Trump, are tempted by the old adage “sell in May and go away”. A sharp decline in US equities could weaken the dollar (which would be rupee positive), but would certainly harm the investment environment (which would be rupee negative). Any way we look at it, RBI is going to be under the gun. My bet, though, is that they will be reasonably successful, which suggests we will continue to see high volatility, but not a much weaker rupee.
The Author is CEO, Mecklai Financial