Circular reasoning

I was having tea with Governor Subbarao a couple of weeks ago and one of the points, amongst many, he made was that it is getting treacherous for him to comment even on what he had for breakfast. The media and know-it-all analysts, like me, dissect even such innocent comments to fathom his thoughts on (these days) the rupee. 

In that vein, I – and everyone else in the market – have been scratching our collective heads about why RBI tightened liquidity in such a strange manner last week. While the articulated reason was to increase the cost of speculation against the rupee, it is hard to understand what this additional stricture would do that the immediately earlier ones hadn’t. 

The (earlier) July 8 circular prohibiting banks from taking proprietary positions in the currency futures market resulted in an immediate sharp drop in the dollar from just above 61 rupees to just below 60 rupees, cutting about 1.50 worth of speculative froth from the market. 

The week later (July 16) circular pushing the Marginal Standing Facility rate up by 300 basis points, other than eliciting squawks of confusion and terror, not to say a bloodbath in the bond market, did precisely nothing to/for the rupee. From 59.35 before the announcement, it strengthened marginally (to 59.15) but in a few days was back to a sagging 59.80 or so. This was hardly surprising since by this time there were very few speculative positions left in the market. Indeed, interbank FX market volumes had already slumped by around 50% since the preceding week, to judge by broker volumes.

Of course, monetary policymaking is no piece of cake at the best of times, and when you are in a crisis that cannot be called a crisis for fear of precipitating a bigger crisis it becomes incomprehensibly difficult. Perhaps the decision was forced by the government’s fear that the rupee falling towards 65 would destabilize the election run-up – any bets on an early election?

And given that the circular RBI slipped in on July 11 – “…for availment of trade credit, the period of trade credit should be linked to the operating cycle and trade transaction” – will certainly lead to a substantial increase in demand for dollars in the near term, they needed something to pre-empt another episode of high-volatility rupee weakness. 

Be that as it may, the trade finance circular makes eminent sense. Since India is a capital-scarce country, it is reasonable (and required by lenders) that companies should avail of working capital, whether in rupees or in dollars, only to fund their operating cycle. Instead, it has been a practice for years to divert these scarce limits to earn arbitrage gains. With this circular, the borrowing horizon for working capital has been brought to where it should be: the borrower’s working capital cycle, which would generally vary between 90 and 180 days. 

The problem is that while the circular is eminently sensible, its timing could hardly have been worse. Already banks are slowing down on issuing LOU’s (letters of intent) for rollovers – our trade finance desk reported a 40% decline in the number of issued LOU’s last week. Thus, import payments that companies were planning to defer through rollovers will come due now – or in a few days or weeks or months. This, of course, means there will be a sharp increase in demand for dollars, putting pressure on the rupee, and, of course, an increase in demand for rupee borrowings, which will now be at a much higher rate. 

With liquidity already squeezed down, things will get more difficult. 
What is more concerning is that implicit in all these circulars is that RBI continues to believe that speculation is the cause of the rupee’s woes. The truth, of course, is that it is economic performance that determines the rupee’s level, with speculation merely accelerating the moves.
While it is a fool’s errand to forecast anything, we have recently developed a model (using DXY and domestic inflation as independent variables) which has tracked the rupee since September 2011 with remarkable accuracy. The tracking error was just 0.2% and the correlation with actual rupee movements was nearly 85%.

If the DXY does, indeed, continue to rise – the Bloomberg consensus forecast for DXY for the end of the year is 86.5 – there is precious little RBI, or anyone else, can do to prevent the rupee from surging back above 60. What is worse is that the dramatically reduced liquidity could lead to sharper swings, creating the very panic the circulars are aimed at avoiding.