Does a rate cut lead to a currency dip?

In recent times, the Reserve Bank of India and its leaders have risen to celebrity status in India. Former governor Raghuram Rajan was the first to receive titles like ‘Rockstar’ and ‘Bond of Mint Street’ in India’s public discourse. He too seemed to acknowledge the accolades in a monetary policy press conference, when he said, “I am Raghuram Rajan and I do what I do.”

Whether a rate cut is expected or not, there is always a huge buzz around RBI’s monetary policy announcements, and the recent one was no exception.

Predictable confusion On August 2, 2017, the RBI cut the policy repo rate by 25 bps (1 percentage point is 100 bps) to 6 per cent, amid building pressure from different stakeholders as headline inflation dropped to a historic low of 1.54 per cent in June 2017. From the constant chatter on mainstream and social media, I observed that commentators seemed perplexed about one question, “If the RBI is cutting interest rates, shouldn’t that lead to depreciation of the Indian rupee?”

The confusion of course emerges from a well-known theory in neoclassical international finance called the ‘uncovered interest rate parity’ (UIP). The UIP aims to predict the spot exchange rate of a small open economy with a fully-floating currency. It states that the expected change in the exchange rate between two countries’ currencies should equal the difference between interest rates in those countries. According to the UIP, an interest rate cut makes the home country’s fixed income securities less attractive and capital flows out of the country, depreciating the home currency.

Many market participants assume that the UIP holds, and that too at all times. For those observers, exchange rate movements around the rate cut must’ve been severely confusing. In spite of most analysts predicting a rate cut on August 2, the rupee appreciated against the dollar by 0.4 per cent from morning till 2 pm, with the exchange rate reaching a 3.5-month low. Just before the announcement, a senior research analyst at Bloomberg Quint said, “If an interest rate cut comes in, it will be taken negatively for the rupee, we could see some depreciation, because the interest rate differential between INR and USD narrows.” It was an obvious reference to the UIP. However, after the announcement at 2.30 pm, the rupee appreciated by a further 0.3 per cent, making it a 0.7 per cent appreciation in a single day.

Some explanations A few factors can explain this conundrum. For one, there is a simple mistake in understanding the variables of the UIP. The UIP is a relationship between real exchange rate and real interest rate differential, not nominal rates. Real rates are nominal rates adjusted for inflation. Since inflation in India has decreased significantly over the past few months, the real interest rate has actually risen and a 25-bps rate cut is not enough to offset the impact of a crash in inflation. In fact, at 4.5 per cent, India has the highest real interest rate in Asia by a margin, with China in second place at 3 per cent.

To solve the conundrum completely, we need to understand certain limitations of the UIP model. First, the UIP assumes that the exchange rate is driven purely by fixed income flows via carry trades and completely ignores equity flows. However, equity inflows have become significant, accounting for 38 per cent of total net purchases by Foreign Institutional Investors (FIIs) in India over the last 12 months. In such an environment, a model which only looks at fixed income flows may not give a correct answer.

Second, the UIP ignores the fact that the international monetary system is hierarchical, with the dollar as the global reserve currency. In the post-Bretton Woods system, the US is the ‘centre’ country with certain structural advantages and India is a ‘peripheral’ country. Thus, US monetary policy decisions spill over to India in the form of capital flows. However, US monetary policy uncertainty, one of the reasons for a weak dollar right now (and hence appreciating rupee), is outside the scope of the UIP.

Third is the impact of political factors. The UIP assumes that in countries with flexible exchange rates and no capital controls, political developments do not affect the exchange rate. However, another important reason for the ongoing weakness in the dollar is the Trump administration and its policies. In line with the ‘America First’ policy, in early 2017 President Trump signalled that he preferred a weak dollar because it would aid American companies sell products abroad. Since the beginning of this year, the dollar has weakened by around 6.6 per cent against the rupee. In a recent article titled ‘Political drama is hitting the dollar hard’, Bloomberg reports, “The relationship (between politics and exchange rate) has grown stronger in an era of quantitative easing, which has distorted the bond and stock markets. Hence, currency traders are more attuned to political developments.”

Critical assumptions All models in the social sciences are developed with certain assumptions in the background. Some assumptions are more important than others because their violation significantly changes the results of the model. Addressing the issue in his book, Economics Rules , Harvard economist Dani Rodrik calls them “critical assumptions”. It is important to remember that reliable conclusions can be derived from models only when the critical assumptions approximate reality. When they don’t, we should look for models which make assumptions better suited for the context.

What, then, is the correct answer to the question, “Does a rate cut lead to currency depreciation?” It depends — on equity inflows, capital flows driven by monetary policy of the ‘centre’ country and political developments, among other factors. When these factors dominate, it is not a good idea to rely completely on the UIP for the answer. As Dani Rodrik says, “The correct answer to almost any question in economics is: It depends. Different models, each equally respectable, provide different answers.”

The writer is an assistant professor at IIM Trichy