Cowing To The Bully : The Flawed Logic Of Not Defending The Re



Think of currency traders as hunting piranha. If you spill even a drop of blood in piranha-infested water, they can smell this ‘weakness’ and pounce on the struggling organism, leaving little but the skeleton behind.

Declaimer: This article was originally in April 2017, and some of the data points may be outdated

The managed float

It used to be believed that the Indian Re was under ‘managed float’, i.e., not fully convertible, and closely policed by the RBI. A ‘currency attack’, read as major bunched-up capital inflows that broke significant price supports hitherto defended by the RBI, would be resolutely defended by fair means or foul.

For long, this has been the case, with one major exception. That was the Re appreciation of 2007, which reversed dramatically in 2008-09. The same thing happened in 2013, which is why Raghuram Rajan ferociously defended the Re in 2014 when it appreciated well below the REER. He went to the extent of speaking out, during the ‘Modi Mania’ of May 2014, that he was ‘comfortable’ with the Re around 60-62.5, even as it was dipping to 58.5.

So why did the RBI hide behind the door, this time when the bully came calling? Like we used to do in school, when the school bully was pushing us, our argument was “Oh!!! That didn’t hurt!”, as if that was reason enough not to react to an express challenge. And like all bullies do, you think he stopped when it finally did hurt? We all know bullying behavior, finally genuflects courage, or to a higher power (usually, a big brother/ school principal, if you had one.)

Recent pronouncements of government officials are pointing to a similar reaction to the challenge posed by the tsunami flows that have come in Jan-March, 2017, pushing the Re well below its 200-DMA, the first time in history that it has broken the line, except for those occasions when it has been returning from a Currency Crisis peak, as in 2009 (from 52) and 2014 (from 69). This time, the Dollar::Re parity was stable, and for one year, had been under-performing the Forward Premium curve, i.e., the Re was below the level it should have been, as suggested by its Forward Curve one year back.

The Value of the Dollar

Before that, almost from the time the current Modi government came in, Raghuram Rajan had sent out a clear message to the markets that the value of the Dollar::Re would be maintained in line with the REER, which calculated the indexed weight of the inflation differential between the 6-currency and 36-currency basket. This meant that the Re would be depreciated by the rate of structural inflation. Even as Raghuram Rajan was on his way out, this rule of thumb was in breach.

Raghuram often said that cycles of Re re-appreciation, if left unfettered, always led to sharp depreciation, even crisis (he said this repeatedly after the 2013 Taper Tantrum).

For one year, 2015, this rule was in breach, leading to moderate Re overvaluation. And then, the recent crack in the Dollar::Re at 67.20 has sent out a clear message that the Dollar::Re would be in free fall, with the RBI living in denial. “oh! That didn’t hurt” is the justification, even as the Trade Deficit has ballooned within a month, and new projections for the CAD are back in Congress territory, close to 1.6%.

So the ENTIRE productivity gains from the reforms of the Modi Govt, have been denied to our exporters. And we are back to our profligate ways of subsidizing our importers and even reveling in the lower ‘imported inflation’, which will push jobs out of India and reduce our export competitiveness. Hardly what you would expect from a staunchly nationalist BJP.

The Currency attacks

Currency attacks are war, by other means. And to think that such a big issue, which is seriously damaging our Balance Sheet, is allowed to go unpunished. The shocking thing is that such an attack has not merited suitable media attention.

It’s a difficult point to make, but let me try and explain. The reforms of the Modi Govt would have increased productivity and reduced costs (like infrastructure costs, power/ energy efficiency, logistics, labor productivity, etc). This would have resulted in overall cost savings, as a result of which the exporter’s cost inflation rate would be lower than, say, the economy’s CPI. Now if the Re were to depreciate by, say, the inflation rate differential, the exporter would have a higher realization for his exports than his cost curve, and his profitability would have gone up, which would have allowed him to increase production. Since GDP is consumption + investment + exports – imports, your GDP falls when imports rise but exports don’t.

So when the Re gets overvalued, you produce less for the world outside, but you export your jobs (and your growth) to the outside world by importing more. In other words, with our weak-kneed response to these ‘hot money’ flows, we have throttled our exports, our production, and therefore, our growth.

Why? Because importers have a bigger voice, ‘imported inflation’ drops and the govt gets better revenues. Or because exporters don’t have enough of a voice, at least compared to importers. An undervalued Re immediately causes a shrill cry from the broader populace, but an overvalued Re does not attract the same noise.

And how insane is the justification for the current change of strategy

And how insane is the justification for the current change of strategy? That we will not react till the BoP deteriorates, i.e., we will not respond to the bully’s push till it hurts? Markets respond to character and firmness, as we saw very visibly in Raghuram Rajan’s early tenure.

Some Mandarin in the RBI would have argued that if you invoke a “Tobin Tax” on capital inflows, there will be a run on the Re, right? And there will be a flight of capital out of India, right? Have we ever tried it? Markets respect the character, and if you know where to draw the line, markets will learn to respect it, just as they learned to respect the steady depreciation of the Re along the lines of the REER, during the Raghuram years.

The sharp losses to India’s exporting sector apart, there will be even greater losses to India’s domestic manufacturers, as Chinese imports come flooding in. The first indications are already available in the March Trade Deficit numbers, which show a sharp 10% increase in gold imports and a $ 2bn spike in electronic imports (must be smartphones from China). So we are back to our earlier misbehavior with the overvalued Re, the same that happened in the Congress years.

Since Trump’s election, where one of his campaign pledges was to name China as a ‘currency manipulator’, the CNY has held its ground at 6.9, even as the Re has gained from 68 to 64, about 6%. While China has used the Korean nuclear crisis to extract a promise from Trump that he would drop the reference (as a ‘currency manipulator’, India has gained no such advantage. Who is to say that China did not orchestrate this (nuclear) crisis to push the US to give up some bargaining chip? Just a Conspiracy Theory, but still.

India needs lessons in the Art of War, which was first written by a Chinese philosopher. Here, far from being a currency manipulator, we have perhaps the most over-valued currency in the world, and we go around saying “It hasn’t (yet) hurt”. We have exported away our jobs, as our exporters lose markets because of the irrational capital flows that are chasing 20% earnings growth in an economy with 5% credit growth. We’ll see about that mirage, but that is the subject of a different article.

Only 4-5 times has the Nifty has been above 24 times trailing earnings, and all such occasions have ended in pain. That means nothing to the cheerleaders on TV, who are already calling this “the mother of all bull runs”. Well, for some reason, “this time it’s different”, or is it?!

Watch this space…..I’m usually wrong by about a couple of years, that’s been my past track record. But it’s usually pretty consistently a couple of years, so beware…….I might be delayed, but I’m usually not wrong!!!



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