Taming the rupee the Rajan way

With the rupee spiralling lower in recent weeks, some experts believe that the commerce ministry is finally having its way in the currency market, now that Raghuram Rajan has bowed out as the governor of the Reserve Bank of India. While that may or may not be true, no one will dispute the fact that Rajan defended the Indian currency quite well during his tenure.

There are several lessons that can be drawn from the manner in which he managed the currency.

Rajan maintained that it was not the business of the RBI to intervene in the foreign exchange market to make the currency strong or weak. He thought intervention was necessary only to control excessive volatility that harmed stakeholders.

Rupee stability was the hallmark of his tenure. When he took over the reins of the central bank, in 2013, the Indian currency slid 11.6 per cent against the dollar. Currency and equity markets were buffeted by taper tantrums then and the rupee took the deepest cut in the EM currency basket, largely due to the country’s weak external balance. But the rupee movement since then has been quite sedate; it declined 2.17 and 4.4 per cent in 2014 and 2015, respectively. The year to date decline in rupee in 2016 is 3.78 per cent.

In contrast, the rupee was 66.4 against the dollar when Urjit Patel took charge; it is down almost 3 per cent since. Implied volatility in the rupee options, that shows the expectation of traders regarding the future movement of prices, has spiked sharply since September. Increase in this metric attracts speculators and short-term traders who can exacerbate the currency’s decline.

How did Rajan manage currency volatility? This was done through various means. One, improving the country’s macros so that the currency does not appear vulnerable to speculators. Two, improving fund inflows from long-term investors; and three, by improving trading conditions. Since the country’s depleting foreign exchange reserves had made it difficult for the RBI to defend the rupee in 2013, Rajan took it upon himself to build a healthy reserve. He was also wary of the destabilising effect of the easy money policies followed by central banks in the US, Europe and elsewhere. It is probably for this reason that he was intent on securing the currency against such instability.

The RBI was on a dollar buying spree though 2014 and 2015, using the rupee strength in this period to buy dollars. The central bank net purchased $32 billion in 2014 and $36 billion in 2015. Dollar purchases in 2016 have so far equalled $12 billion, helping take the forex reserves above $370 billion.

The current account deficit in also currently in check, aided by benign commodity prices and the country’s falling gold imports.

Regulations put through under Rajan have reduced short-term foreign holding in Indian debt securities. Foreign direct investments have also soared over the past couple of years, ensuring that the money coming in to the country is more long-term in nature.

The trading regulations are also much tighter now to reduce external influences on the rupee. The link between the domestic inter-bank rupee market and the offshore non-deliverable forward (NDF) market was one of the causes for the rupee weakness in 2013. Rajan moved to close these channels by placing curbs on proprietary trading by banks in currency markets and placing restraints on banks with overseas operations. He also put through various measures to improve liquidity in the exchange traded currency futures and interest rate futures since a strong domestic market can help counter speculative attack from offshore investors.

His moves to internationalise the rupee by introducing masala bonds and encouraging settlement of foreign trades in the rupee also added heft to the Indian currency.

The Centre and the RBI have had numerous spats over the last couple of years over the rupee. The commerce ministry has been vocal about the need for the rupee to depreciate to help the country’s sagging exports. However, Rajan held his ground, maintaining that this would hurt other stakeholders.

While the currency is likely to be turbulent in the next few months, following Rajan’s practices could help tide over this difficult period.