The Indian Economy Blog

December 21, 2007

The Rise And Rise Of The Rupee, Or How To Screech A Galloping Elephant To A Halt Atop Of A Dollar Bill

Filed under: Business,Growth,Media & Economics,Monetary policy — Edward @ 2:45 am

Well my advice on this one – the galloping elephant part (you know, we’ve had the Tigers, the Lynxes, and the Giant Panda, and now its the turn of the Thundering Elephant to lead the global economy onwards and upward) – is not to try it. The very least that could happen is you get to fall off. But before we get into the full force of rhetorical frenzy here, I’m afraid that I’m not quite done yet with the Economist India correspondent (following my rather hamstrung attempt to caste myself in the role of Emile Zola at his expense yesterday), since as I said at the end of that post, our sterling correspondent, having failed to overheat anything beyond his own curry-ridden palate, has now moved on to what has to be the macroeconomic story of the year, the seemingly inexorable rise and rise of the Indian rupee.

As he himself says on the matter:

The rupee’s rise may be less dramatic than that of the Philippine peso, Brazilian real or Turkish lira. But it is uncomfortable nonetheless.

Quite so, just like a strong vindaloo without the de-rigueur mango lassi accompaniment a rising currency produces its own kind of dispeptic discomfort. But hold on a second, mightn’t a rising currency in India actually be good news, and in any event inevitable? Nothing it seems is ever considered to be unmitigated good news where India is concerned in the eyes of our valiant correspondant, since everything needs to be tinged with its due and measured dose of schadenfreund.

What then is all the fuss about? Well the rupee certainly is rising. As the Economist India corresponent points out, India’s currency has strengthened by about 15% against the dollar in the last year alone, and by over 10%, on an inflation-adjusted, trade-weighted basis, since August 2006. And why is this happening, or why is it happening just now? Again our hero is pretty much to the point:

This vigour is due to a strong inflow of foreign capital, some of it enticed by India’s promise, the rest disillusioned by the rich world’s financial troubles. The net inflow amounted to almost $45 billion in the year to March, compared with $23.4 billion a year earlier.

So he is pretty much to the point here – India’s enchantment is in part a question of disenchantment with others – although I can’t for the life of me understand why the latest data he has to hand is from back in March. Can’t this guy ever do a professional job? Data up to the start of December is readily available on the Reserve Bank of India website here, and fascinating reading it is. Since this is a moment of almost historic proportions, perhaps my colleagues on this blog will be understanding and permit me a small break with tradition in actually posting an exhibit-A type chart.


As we can see, and bearing in mind that the net inflow of external funds in the year to March – as proxied by the level of foreign exchange reserves held at the Reserve Bank of India – was $45 billion, the net inflow between 31st March 2007 and the start of December has been around $74.4 billion, or not that far from double the total amount that entered in whole fiscal 2007/2008 in just 9 months (and $41 billion of this since 9 August, more on why this date is important later) and fiscal 2006/7 was itself a very strong year for fund inflows, as we have already mentioned. All of this is, of course, simply staggering, but unfortunately, it seems, you aren’t going to read about just how staggering it is in the pages of the Economist since over there we are still looking at last years data (the last time I cricised them they said I was cross, this time I am angry aren’t I, does it show?). As can be seen directly from the chart, the money really started to flow in from mid-September and continued flooding in at a very fast rate until roughly mid November.

The locus classicus on this whole state of affairs is without a shadow of a doubt Morgan Stanley’s Chetan Ahya, and really it was this post of his which alerted me to the extent and significance of what was that was happening in India.

Over the seven weeks ending November 2, 2007, India’s foreign exchange reserves have increased by US$34 billion (annualized inflow of US$250 billion). Indeed, the trailing 12-month sum of FX reserves has increased to US$100 billion. This compares with the average annual increase of US$38 billion over three years prior to these seven weeks. With the current account still in deficit, the increase in reserves is being driven largely by a spike in capital inflows and to a very small extent because of conversion of non-dollar reserves into dollars. During the last seven weeks in which FX reserves have shot up, we believe that capital inflows would have been US$35 billion. Out of this, not more than 10% has been on account of FDI inflows. Non-FDI inflows including portfolio equity and external debt inflows form a major part of these inflows.

While the inflows are pouring in at the annualized run rate of US$250 billion, in our view, currently the country can absorb only about US$40-50 billion of capital inflows annually without causing any concern on attended risks of overheating. The key question policy makers are grappling with is how to manage these large capital inflows. As the strong growth in domestic demand has resulted in overheating of the economy recently, the central bank does not want to leave such large capital inflows fueling the domestic liquidity. Not surprisingly, the central bank has accelerated the pace of the sterilization by way of issuance of market stabilization scheme (MSS) bonds and an increase in the cash reserve ratio (CRR). Over the last 12 months, the RBI has sterilized about 58% of the foreign inflows. The sterilized liquidity (excess liquidity) stock including reverse repo less repo balances, MSS bonds, government balances with the RBI and the increase in the cash reserve ratio has shot up to US$77 billion as of end-October 2007 from US$19 as of end-October 2006.

Now while the issue of whether or not India is now overheating once more raises its ugly head here, the context is now quite different, and it is clear that the Reserve Bank of India is having to struggle with a very different problem set from the one we were looking at back in the winter of 2007/8. The problems that may arise in the wake of such a massive influx of funds, and especially if the flow continues (or even increases further as it may well do if the problems the developed economies experience in 2008 turn out to be greater than appear to be the case at present), and doubly so the if India’s attraction only rises further on the back of a discovery that not all the emerging economies are as structurally sound as they appear to be.

The 9 August 2007 date is a significant (and even historic) one, since that is the day that French banking giant BNP Paribas announced it was suspending three of its funds — Parvest Dynamic ABS, BNP Paribas ABS Euribor and BNP Paribas ABS Eonia — since they were considered to be unduly exposed to US high-risk property loans. BNP Paribas Investment Partners, a unit of the French bank, chose that day to announce that the funds would forthwith accept no redemptions or subscriptions, and in making this announcement the so called “US Sub-prime Financial Turmoil” problem was born, and with its arrival the history of the entire global economy was given, it seems, a gentle turn of the page.

One outcome of the Paribas decision that no-one perhaps envisaged when it was announced was that half a century of severe distortion and imbalance in global economic dynamics (you know, that old-hat “rich economy”/”poor economy” thing) might be given a hefty push in the direction of unwinding itself across a five to ten year window. Acceleration and recoupling is now the name of the game. (Since explaining all this involves getting involved a little bit in what the Bretton Woods II architecture is all about, as well as in the significance of what is happening in Japan, about which I have previously posted something here, and about what Bretton Woods III might look like, and how quickly it might now have to arrive, I will not enter more into this intriguing topic, but will save it for a separate post next week).

Now I don’t think it really needs saying that India is hardly to blame for the sub-prime blowout, or for the fact that the whole Bretton Woods financial architecture is looking extremely shaky at this point in time. One thing is sure though, and that is that given that money is leaving one place (some of the G7 type developed economies), rather than intentionally heading somewhere else, India now finds itself reeling under the weight of a quite sudden and unexpected inflow, which she may seriously be asking herself what it is precisely she has done to deserve, since what seems to be involved is some form of reversal the directional arrows normally though to be associated with the expression “capital flight”.

What is obvious to me at least at this moment in time is that, amongst all the growing risk you can see steadily accumulating itself out there (and here I would part company slightly from the Morgan Stanley China team, since I think the dial registering inflation risk in China is now starting to turn dangerously red) India looks to be as good a substitute for a safe haven as you can find these days. And so in the money comes.

The question is that while India’s new found growth potential and relatively tame inflationary environment is in part a by-product of the fact that the rupee has been allowed to steadily rise, the ensuing process is not, to use our Economist India correspondent’s own euphemism, a comfortable one. And in the same way that the representatives of the European Central Bank express concern about “violent changes in currency values” – meaning by this the unduly rapid rise in the value of the euro – the gentlemen over at the Reserve Bank of India and the representatives of the Singh administration have every right to speak out plainly to the effect that countries like India and Brazil (for all their tremendous potential) simply cannot shoulder the whole weight of the massive global correction which is now in course.

These are developing economies, and the whole path of their development process can be distorted or skewed by an excessively hot-house fashion injection of funds. In this sense I fully endorse the preoccupations being expressed by Chetan Ahya about the rate at which the inflows are pouring in. An annualized run rate of US$250 billion is simply enormous in an Indian context, and historically (in proportional terms) unprecedented anywhere I think. So regardless of the validity or otherwise of Ahya’s suggestion that India currently can only absorb somewhere in the region of US$40-50billion of capital inflows annually without producing overheating risks (here we go again, my guess is that this number could be higher, but this is just that, a guess, since I certainly have not done the requisite studies, but who, in all honesty, really has, or is in a position to realistically estimate what is involved here. A brave man, I would say).

This is not the moment to take all this off into those still very much uncharted waters. My friend and colleague Claus Vistesen recently had a stab at identifying some of the issues involved in this Compass and Charts Needed post. Clearly a coordinated and concerted response from the entire central banking community as well as from a rapidly enlarged G7 type forum is badly needed (was the case for enlargement of the G7 ever so clear as it is now, what the hell is Italy doing in there while India and China are out, our institutions simply are not keeping pace with events). I, for my part,only want to register here that something profound and important is taking place, and that there are no easy answers to hand. This is not simply a tepid repeat of events we have all seen far too often in the past, and recipes (which is what I fear we are being offered in the pages of the Economist) will not suffice (even if they are of the softer Chicken Tikka Masala variety rather than the undiluted Vindaloo one). Starting from this recognition, let the debate as to where we go next, and what to do about it, commence!


  1. Interesting viewpoints, and uncharted waters indeed. Will look forward to your subsequent posts.

    Comment by Aaman — December 21, 2007 @ 9:44 pm

  2. Edward, don’t laugh. I am just a layman. What would be your take on pegging the rupee to the dollar, if such a consensus was even achievable in the highly fragmented Indian parliament? My only reason for asking such a rhetorical question is my personal experience with Indian businesses. Woefully anecdotal, I admit, but almost every business man I know in India (don’t know any business woman in India) is chasing export to the US as the Holy Grail, whether the product is software or diesel engines. Wouldn’t a rupee-dollar pact make economic sense? Or no?

    Comment by Floridian — December 23, 2007 @ 6:22 am

  3. “Edward, don’t laugh. I am just a layman.”

    Hi Floridian. I’m not laughing. It’s a reasonable question, but I think this is both undesireable and impossible. And this for two priciple reasons.

    Basically, as I will argue in next week’s post, currencies in the developing world are in many ways substantially undervalued. This is why people developed the Purchasing Power Partity measure to try to assess comparative living standards. Now by dollar valued GDP the developing world only account for 20% of global GDP, but on a PPP basis they account for 40%. They are also growing very often now in the 8-10% pa region. So this is the “imbalance” which is now going to unwind very quickly. Within a very short space of time (hard to say exactly how short, but it could be as little as 5 years) the developing economies will start to be responsible for over 50% of the global economy, and the lions share of growth in the global economy (they nearly have this already).

    This change is huge, since the 1990s and the ongoing debate about “economic divergence” bigtime. My feeling is the consensus discourse and mindset has yet to get its mind round the implications of all this.

    So that is the background. I said there were two reasons why the rupee couldn’t peg.

    The first is the undesireable one, look at China. China is struggling with a severely undervaluaed currency, a major inflation problem, low internal consumption growth when compared to export growth, excessive concentration in fixed capital investment at very rapid rates, and now I think (Aha!) a significant danger of overheating. They need to loosen the yuan. I mean I’m not saying that this is all as obvious as some people seem to think it is.This won’t be the one stop solution to all China’s (and the US’s) problems that many seem to think it will, since taking the lid off at this point and floating will undoubtedly only attract an even greater increase in the incoming flow of funds. Especially if they keep raising interest rates to try and choke inflation at the same time as the Fed is lowering. Basically, having spent a long time studying the growing inflation problem in Eastern Europe and susbsequently in Russia I would say that without a shadow of a doubt China is going to have a serious problem with the decline in the volume of the 15 to 19 age group that is happening right now after so many years of low fertility. This will only stoke up inflation even further.

    So the undersirebility argument is simply this, you can let your currency rise, as India now is, at, say, 12% per annum (vis a vis a dollar which is constantly falling in relative terms, it has to, and possibly a euro which has to now have a downward correction too, for the same reasons basically), or you can wait till you get to where China now is and have a real headache. Sound sense indicates the former path is better, although not easy. This is why we do need an expanded G7 and collective policy on the undesireability of “violent” currency movements, and we need it now.

    Then there is the impossibility argument. Well I think I have also been making this already. You can’t fight history, and you can’t drain an ocean with a teaspoon. India is going to get comparatively richer, and this will mean the currency will have a higher value. Local, central bank driven, monetary policy is increasingly impotent in the face of globalised capital markets and fund flows, as we are seeing in country after country. Indeed since the rupee (or rupee denominated instruments, property) is going to become one of the currencies it is desireable to hold given that there is guaranteed economic growth and currency rise, the big problem may well come when some of those large central banks start to do the rational thing and hold a significant share of their reserves in rupees.

    Now, I would wish to emphasise one more time that this is not simply a one way street. There are pluses and minuses here. Those, whom you mention, who are trying to develop export oriented industries are undoubtedly going to have a hard time of it, of the “just feel the pain” variety. But there is little realistic to be done here. You can’t simply turn the clock back, and return to the India of the early 1990s, even if you wanted to. So it isn’t clear what kind of development process India is going to have, and what kind of balance (eg) there will be between services and industry. I have no answers to all this, I’m afraid, simply questions.

    Comment by Edward — December 23, 2007 @ 12:44 pm

  4. The solution to the current problems is that the US will have to change the way it manages its reserves. Like other countries it would have to hold foreign exchange reserves in a basket of currencies other than the US Dollar simply because indeed the world is changing. Blaming China is not fair. Both China and India are poor countries and cannot share the burden of runaway debt and currency-printing in the so-called rich countries.

    I am more sanguine about inflation in China. A lot of it is seasonal or one-off. Besides, China seems to have found a roundabout way to get rid of its dollar reserves (its SWF).

    The RBI is probably one of the best managed central bank in the world. It shows why political control is not always bad for central banks.

    As for the G-8, it is just a grouping of White people + Japan (interestingly the Japanese were considered honorary whites by Apartheid South Africa). Just like before World War II. I suspect that racism is still strong at the upper echelons of power in the Western world. Another way to look at it is that China and India are very sovereign/independent countries. Even Russia was added to the G-8 when it was under Yeltsin. Would it have been added under Putin? I don’t think so considering the reluctance to add it to the WTO. The G-8 should be disbanded. It is meaningless now.

    Comment by HmmBut — December 23, 2007 @ 10:25 pm

  5. Edward and HmmBut, excellent points. I was only thinking of the near future when I asked about the desirability of pegging the rupee to the dollar. It could be a “have your cake and eat it, too” strategy, as China seems to be following, with its artificial rein on the yuan. In the long run, neither China nor India will be able to fight Mother Nature and their currencies will rise to reflect their economies.

    The G-8 does seem archaic in this day and age, doesn’t it? Although not intentionally a white club, decades of mindset does take time to change. Kind of like the Dow Jones INDUSTRIAl Average as an index.

    Comment by Floridian — December 23, 2007 @ 11:25 pm

  6. I just want rupee pegged to dollar. I don’t know who else is benefitting from this rupee-dollar joke other than currency speculators. Pretty soon India will lose all export industries other than IT.

    But if you ask an economist, he will will invariably give you all that mumbo-jumbo about inflation etc etc, things they memorized from economics classes in college.

    In a growing economy, inflation is not that bad. I would rather peg rupee to dollar and have China’s problems. Have you ever been in China. If currency peg were so bad, how did they grow so much? Their economy is now 3 times the size of India’s. I would rather have China’s infrastructure and income along with their headache.

    Comment by Dustu — December 27, 2007 @ 12:08 pm

  7. Aah! The Pain of plenty!

    India has many ways to drive down the value of the rupee if it really wanted to. I am thinking of the central gov and RBI working very much in cahoots on this one. It is only that all of these measures involve making India a worse destination for capital.

    Thailand had a solution where a certain percentage of money had to be kept in non-remunerative deposits. THis was sought to keep speculative “hot money’ away. This could be tried here.

    The rbi/sebi/finance ministry circular asking every fii to register is a positive step. Keep it up.
    Eliminate the maldives tax loophole. You’ll immediately see how much of this money is not recirculated.

    Fiscal loosening. Build infrastructure like no one’s business. Improve oversight so that it doesn’t end in the wrong pockets. I am personally in favour of a large fiscal infusion into building judicial, education and health infrastructure.

    Another “out-of-the-box” solution. Treat the RBI as a institution owned by all the taxpayers. Send a dividend to the accounts of all those who hold a PAN card. Your money is printed and distributed fairly.

    Comment by Prakash — December 27, 2007 @ 6:38 pm

  8. Interesting points Prakash. Agree with most. I have reservations about the last two. Fiscal loosening might worsen inflation (though rupee appreciation may act in the opposite direction). As for the last one, I really do not understand the point of it. RBI is a lender of the last resort. Like China and Singapore, our foreign reserves maybe transferred to an SWF but this is liable to financial mismanagement. Perhaps sending out vouchers is a good idea.

    All in all, we cannot expect the US to change its reserve management policies. So most other countries will have to adjust to this reality. India and China are lucky in that we have a huge captive market. So the best answer is strong domestic organic development rather than export-led development formula.

    Dustu, good point about having the growth and infrastructure along with the headaches related to the peg. China’s accumulated dollar reserves are not completely bad either. It will continue to have the same buying power as the US. If the dollar goes down both countries will lose some purchasing power and vice-versa. The result is that China is already competing in buying assets and lending international capital. All the while, it is developing at a breakneck pace and accumulating skills and resources. I am not sure if we can pull it ourselves though.

    I am interested in Edward’s views. Thanks for this superb post Edward.

    Comment by HmmBut — December 29, 2007 @ 5:25 pm

  9. It seems to me that there a lot of better uses of fx than trying to peg the rupee, or keeping fuel prices subsidized. How about going after some of the most egregious tariffs, like the over 100% duty on used cars, or taking a few items off the “prohibited list” of imports. Further spending on infrastucture that widens the public borrowing requirement further would likely suck in more “hot money”, rising the rupee in the medium term. Even adopting a maximum tariff of 40% would be a step forward in promoting the long run efficiency of the Indian economy.

    Comment by jim hass — January 17, 2008 @ 6:40 am

  10. Good repartee here folks – BUT

    Here is a contrarian view from an nri doing business in both continents – America and India and making home both places;

    1. US is not “yet” falling into the ocean – trust me – the market reported “bearish” hype notwithstanding;
    2. US has many many eco-systems and grounds for excellence, and there is no second player in sight – not as yet anyhow; China and India included (and I see none being formed either, so no emerging threat);
    3. The RBI, (who is lauded here in these posts) is out of funk. With a Bad (or poor) Leader. To stifle capital formation (as they are actively doing) in a “flattening” world is exactly the wrong thing to do; restricting full capital account convertibility in the face of the obvious is to illustrate myopia. Controlling commodities is what the GOI wants to do – fdi “this” and fdi “that” – all bogus Marxist thoughts. I guarantee that if the capital account was deregulated tomorrow, all manner of INR’s would be traded for the $ and they shall make a bee-line for US shores – The US is studiously the least cost producer for many items and services (risk adjusted); In the US, as an example I can freely buy a first class office building for around $250 per square foot while I can restrictively buy (after a ton of hassle its “apology” equivalent in Mumbai for $1,000/sf or London for $4,000/sf! India is great buy I ask?? Hello??
    4. The Indian worker has become “silly” in their MTV enhanced expectations – all India has (woefully) is/was a marginal labor cost advantage, contained English speaking workers and so Companies came – trust me (and as a Cross Border Chief Executive) now it is cheaper and better for me to recruit in the US rather than hire an Indian. And to top it off, the average Indian CEO is pathetically inadequate in skill sets, untrained and mainly a “shop-keeper” – wholesale to retail cycler. Show me 10 products “Made-in-India” on global shelves that people jump to buy…. I have found none so far! Tata’s Nano at $2,500?? a global best of class product – shoots In saw it too – and it was pathetic! a piece on non ingenuity!
    5. So, in my humble opinion, and while I too may be accused (and am guilty) of following momentum in some sense, India is sadly, still, a basket case and chances are that is where it will remain. And this “hot” money will flee as soon as the foreign investor has to deal with the ITO and the RBI official, as an example. Which mostly are staffed by corrupt, hollow, inadequate, un-skilled, marginal, thoughtless, non-customer centric folks, and whose factories produce poor quality and the country persists to be home of many ills – even after 50+years of independence.
    So ladies and gents, lets us get real – the US is best of class, great value and true promise. All others have to wake up pretty early in the AM, to catch up with the average US worker – the current political leadership in the US notwithstanding. As an Indian NRI. I still feel compelled to root for the US and the $! Good folks will see its value. Many technology wonders are emanating from the US (and I know so), and there is a good chance that many of these technologies will continue to make large wealth through enterprise in the US and not in China nor India.

    Comment by sunil — January 21, 2008 @ 6:41 pm

RSS feed for comments on this post. TrackBack URL

Leave a comment

Powered by WP Hashcash

Powered by WordPress