Joined at the hip: euro and rupee

For those that cared, INR reached its all-time-low point versus USD at 55:1 (at least from the Google Finance data since 2004) in Dec’11/Jan’12. The trend has since reversed as of Feb first week. A friend posed the following intriguing questions:

  • Why did INR suddenly became so expensive without any drastic domestic reason in plain sight?
  • Why were other EU export-dependent “Asian tiger” currencies such as yuan (China), yen (Japan), and won (S. Korea) not similarly affected?

In framing my response to him, I’ve gathered enough material (mainly from financial news sites, both Indian and foreign) that corroborates my longtime hunch that INR’s fate is inextricably tied to that of EUR. This “joined-at-the-hip” theory manifested itself in late-Dec 2011 when the fears of impending collapse of Italy was at its peak. On Dec 15, 2011, INR plunged to its all-time low of nearly Rs. 55 for $1. Along came the widespread calls from all and sundry for RBI to intervene massively in the currency market to “save rupee from eventual collapse!” The levelheaded RBI governor D Subbarao, supported by Finance Minister Pranab Mukerjee, promptly resisted any such temptations, but RBI’s hands were also tied as I’ll show you in this post.

What changed overnight?

The central argument for the situation reaching dire straits in December 2011 goes along these lines:

Before the 2008 financial crisis, India had maintained healthy foreign exchange reserves to sustain import bills for the next 15 months. It has since begun declining mainly due to the stimulus spending plus central government’s huge subsidies on oil and others, worsened by general mismanagement of economy. In the Dec/Jan period, India’s foreign exchange reserves dipped below the psychological comfort zone of $300B, which could now sustain imports for only 8-9 months. As a percentage of forex reserves, India’s immediate maturing external debt reached its highest point in a decade. This forced government’s hand to announce a dollar swap with Japan that boosted forex reserves by $10B. But that Japanese gesture came too little, too late.

Now, it’s easy to understand why Euro crisis had disproportionate impact on India over other Asian tigers: the widely acknowledged fact that RBI simply didn’t have the wiggle room to act even if it wanted to because of diminishing forex reserves. As Indian investors dumped euro and bought dollar (I remember reading Indians were among the top hoarders of euro but cannot find link), RBI became even more hamstrung in its ability to act. From this article:

As large banks, investors and financial institutions started selling euro and bought dollar, the latter appreciated against all major currencies including rupee.

One school of thought is that unlike its Asian peers, the RBI could not have intervened in a big way in the currency markets with its fragile holding of foreign exchange reserves.

“The rupee weakness is basically due to the European crisis and has nothing to do with the domestic economy,” added HDFC Bank’s head of forex operations.

Amid the widespread clamor for RBI to do _whatever_it_takes_ to stop the rupee slide, its levelheaded, market-friendly, go-slow approach was praised by some economists:

Let’s be clear. For all the criticism the Reserve Bank of India (RBI) has drawn on its inflation response, it deserves to be commended on its exchange rate policy — essentially allowing the rupee to float over the last three years.

What has happened since mid-January? Is Europe recovering?!

Europe is not making headlines anymore, though ground situation may/may not have improved. Germany actually expanded in January against expectations pointing to a positive mood at the minimum.

Meanwhile in India, inflation has reached its 2-year low of 7.5%, prompting RBI to contemplate cutting interest rate after 13 successive hikes! Central governance is showing signs of getting back on track with the silence in anti-corruption agitation. 100% FDI in single-brand retail came into being despite the multi-brand getting stuck in controversy.

This article shows that January 2012 reversed the trend of declining foreign investments. Easing of European concerns increased FIIs (Foreign Institutional Investments) into India in Jan. Whether the ground situation has really changed in Europe is an open question, but the market sentiment certainly says so.

Liquidity infusion in Europe

The January stock market rally is also attributed to the steady liquidity flows from FIIs. This inflow is said to originate from Europe where the European Central Bank has started to expand its balance sheet aggressively to improve the overall liquidity environment in the Euro zone. The emerging markets have some spill-over effect.

The liquidity injection in Europe is not as dramatic as the quantitative easing in the US in 2009, but is steadily improving the tight liquidity situation in Europe. European banks are among the biggest foreign lenders to Asia. As stability returns to these banks, the passthrough of their funds to Asia as its biggest lender will increase. This implies the liquidity flow may not stop very quickly as feared by many analysts.

Going forward, inflows to emerging markets such as India may also increase because of the weaker dollar . This indicates that this January rally may last a little longer.

P.S.: With this quick and dirty late-night exercise, I realized how hard it is to google for some articles I’ve read in the recent past (2-3 months). It’s a challenge to choose the right keywords!