When RBI lost to speculators
By
Mathew JohnWe have in our previous daily and weekly mails consistently argued that the RBI cannot maintain a stable exchange rate and at the same time control inflation with monetary policy when capital can flow into the country freely from outside. We had in other weekly reports and comments to Newswire 18 commented that the RBI continues to hold the rupee it will only loose to speculators (like the George Soros type). We had said citing the concept of reverse speculative attack which was being subject to by speculators in the NDF market.
We said, “The fire fighting exercise started with the RBI hiking interest rates firing all its policy levers. Overnight interest rates which hovered below the interest rate corridor in March flew to above 70% levels. Panic spread in the market and banks had to resort selling its dollar holdings to raise rupee funds. Then came the pile driver, when it hiked interest rate on the last day of the financial year thereby aggravating the skew in the money and the currency markets. All the good work of meticulous management of the monitory policy was undone in a period of just three weeks. This showed that the RBI just could not keep the interest rate and exchange rate steady and the flows into the economy continued unabated as they were attracted by the higher yields, a self fulfilling prophesy – exactly a “reverse speculative attack” **on rupee a scenario Economist Ila Patnaik forecasted in 2003.’
This seems to have exactly what has happened. Bloomberg report (
http://www.bloomberg.com/apps/news?pid=20601091&sid=afF60XIVRswc&refer=india ) which came out last week vindicates our stand. In this report it says that PMICO ( Pacific Investment Management Co.), the worlds largest bond fund went long of INR in the NDF* market. PIMCO chief Bill Gross is considered to be the worlds most influential financial brain after Allen Greenspan in the latter’s heydays. In the Bernanke era, Bill can be considered arguably more powerful than Ben Bernanke himself. The reports adds that PIMCO bought millions of INR derivatives to profit from interest rates in India, the world's second-fastest growing major economy. The money manager has purchased non-deliverable rupee forwards tied to the future value of the rupee as these contracts are attractive because nation's bond yields are the third-highest in Asia.
*Non-deliverable forwards involve no physical exchange of currency and are typically settled in U.S. dollars. They are a type of derivative, a contract whose value is derived from stocks, bonds, currencies or commodities or linked to specific events such as changes in interest rates or the weather.
The report says that global investors are buying derivatives to benefit from India's yields because they are restricted to owning less than 2 percent of the $250 billion local-currency government debt market. The currency gained 7.9 percent in the past three months, prompting speculation the Reserve Bank of India stopped buying dollars after a record $11.9 billion of purchases in February.
The currency has appeal as a target for the carry trade, in which fund managers borrow in nations with low interest rates to invest in assets with higher returns. A one-year forwards contract carries an implied rate of about 8.43 percent, versus a yield of less than 5 percent for U.S. one-year Treasuries. Exactly this is what we are saying for a year, rupee is now the world choice of the most favorable carry currency in developing markets.
So why did RBI leave the rupee alone?
Simply because, it played into the speculators hands. When these large funds were long INR and the RBI seems to not to care and bought massive amounts of USD to keep the rupee steady.
Now look at NDF volumes which according to well researched Mumbai International Finance Centre report says us about USD 500-750 mn ( page 56 of the IFC report). Foreign investors have got yet another reason for investing in Indian stocks as the rising rupee has multiplied their returns twice over what domestic investors get. The Indian stock market has given a return of 5.6% so far in the current quarter in rupee terms, while its return in US dollar terms is a whopping 12.5%. RBI would in order to keep the rupee steady had to buy huge –
amount in the domestic market plus what the FIIs are bringing. Also, the ECBs rose to about USD 4 bn in one month as higher interest rate started to bite India inc and they started talking cheaper foreign loans. This is exactly what happened in February (see graph*).
*Joshua Felman
Still the RBI daily intervention could not keep pace with the huge amounts speculators brought into the market. RBI had to throw the towel and the result is for everyone to see as rupee collapsed from 44.22 to 40.62 (see graph)
So in fact RBI presence to steady the USD/INR at any cost( cost to exporters, importers, and tax payers by cost of sterilization , borrowers due to high cost of borrowing due to easy money absorbed in the system in fact caused the highest volatility in the currency markets in about 25 years. (see graph*)
*Joshua Felman
During May 2006 Gold saw a high of $ 732. The same way people were expecting the metal to touch those levels during this year also. However, It could not penetrate the Psychological barrier of $ 700. Now looking at the way it has taken a steep fall from 700 levels to 654 the crucial previous break out level, it appears that the earlier band of 666-696 has moved to 654-674. 
