“People who argue that speculation is generally de-stabilising seldom realise that this is largely equivalent to saying that speculators lose money, since speculation can be de-stabilising in general only if speculators on the average sell when the currency is low in price and buy when it is high.”

That was the classic case for speculation made by Milton Friedman in 1953.

Speculators can be general de-stabilisers only if they, on the average, accentuate a prevailing price trend; but, if they were to accentuate a prevailing trend, they would be making losses.

Would rational “speculators” indulge in that sort of speculation? No.

Therefore, “speculators” have a stabilising function to perform in markets — buying at market “lows” and selling at market “highs”; that was Friedman’s logical insight.

“Speculators” though would be perfectly legitimate profit-maximising private economic agents as long as they do not see the top or bottom of a currency or any other financial market. Their actions, in such an environment, would highlight to the policymaker the need to put in place such measures as would indicate to them (the speculators) that a market top or bottom is at hand.

Legitimate speculation

That insight seems to apply so very well here in India at the current juncture. Only that Indian policy-makers seem to be oblivious to that and are going about blaming speculators for the rupee’s woes in the foreign exchange markets. They also attempt to make speculation “costlier” through the medium of higher interest rates.

But that is nothing new in our markets. Indian policy-makers have traditionally sought to blame speculators — be they in the currency markets or in commodities or in stocks — for “abnormal” price movements, for which they are criticised.

Indeed, our policymakers blame speculators only when price movements give the impression that they are not in control and therefore are criticised; as long as they are not criticised, our policy-makers do not mind the activities of “speculators”.

If that characterisation gives the impression that our policymakers understand the role of “speculation” in markets, the accompanying move to “hike” interest rates to deter speculation dispels that.

Higher interest rates — and much higher rates than current levels — are indeed required to stabilise the rupee, but those higher rates will not kill speculation. Such higher rates are actually required to bring in speculators into the market in the rupee’s defence.

Indeed, ironically, such higher rates are required to firmly signal the authorities’ resolve to improve the economic fundamentals for the rupee even in the short-term, a la Paul Volcker’s act for the US economy in 1979-80.

And a perception of “improved fundamentals” will then strongly aid the rupee’s recovery as “speculators” come into the market to perform their stabilising function — buying the rupee from its lows and pushing it higher.

Unfortunately, that resolve and signalling is found to be seriously wanting — both at a conceptual and at the practical level.

Not only has the Finance Ministry trotted out the “explanation” that the liquidity tightening and higher interest rates measures are meant only for the foreign exchange market and will not result in any “general” increase in interest rates — as if the “general” interest rates markets and the foreign exchange markets are two nice, separate compartments insulated from each other. The Reserve Bank of India (RBI), too, has not followed up on its “announcements” to tighten liquidity by restricting liquidity access for banks and selling government bonds from its portfolio. The rupee is nearly where it was when the RBI announced the measures on July 15, 2013.

(The RBI reinforced its measures of July 15 on July 23, but this has to be carried through to its logical conclusion).

Market fundamentals

So, what are the market and economic fundamentals whose underlying profile should be significantly changed by the RBI’s liquidity tightening and higher interest rates — and which would then bring in stabilising speculators into the market?

Nothing better exemplifies the weak market fundamentals for the rupee at the current juncture than the fact that the CNX IT index of 20 top Indian IT stocks has posted a strong increase of 35 per cent in the past 365 days. A more powerful signal is that this index has risen nearly 18 per cent in the past 30 days (as of July 22).

What does this strong rise in the IT index imply?

It shows that the IT complex is now very comfortable leaving a significant part of its foreign exchange (FX) receivables exposures un-hedged. For, only if its receivables are un-hedged will it be able to cash in on expected continued weakness in the rupee and post much higher rupee realisations on its dollar earnings in the ensuing period. And the stock market well knows that. It, therefore, is pricing in the un-hedged FX earnings of the sector at accordingly high levels.

Effectively, the IT sector is not supplying much of the current FX it is earning into the markets as it perceives continued dollar strength.

A more damning indictment of the economics underlying the rupee’s FX woes is available.

The Indian Electrical and Electronics Manufacturers’ Association (IEEMA) has petitioned the Prime Minister that despite a 35 per cent fall in the rupee in the past two years, imports from China are still price-competitive and are swamping the Indian markets.

The bottomline: We are facing a high domestic inflation environment. The rupee is bound to remain weak in that scenario as the relative prices of overall imports remain competitive, pressuring the BoP. How can we blame speculators for that?

(The author is a Chennai-based financial consultant.)

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