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Perspective

The honeymoon is over
The forex market seems to be ignoring the eventuality of a capital exodus

Paul Mackel

In the run-up to and after India’s parliamentary election in May this year, capital inflows were very strong, as many investors were looking at the nation through a completely different and more optimistic lens compared with the situation a year ago. But strong capital inflows were matched off by the central bank replenishing its foreign exchange reserves. This year, capital flows into local equities and sovereign debt reached just over $25 billion, while spot forex reserves increased by $24 billion (as of 11 August and 1 August, respectively). The end result of these offsetting flows was that volatility in dollar-rupee steadily compressed. There are other reasons why rupee volatility declined, including the influence of low volatility seen across different asset classes and regions.

But as some market tremors have emerged more recently, the rupee’s volatility has also started to increase. Some measures would put the rupee’s level of volatility versus the US dollar back at levels seen in early February. Consistent with this, we took note of the Reserve Bank of India’s (RBI) recent policy statement, in which governor Raghuram Rajan highlighted how emerging market economies have received large portfolio inflows and these could be at risk if the market turns jittery about the end of the US Fed’s tapering or geopolitical risks. He has not been alone is voicing concerns. In recent weeks, other central bankers have done the same, including the Reserve Bank of Australia and the Philippines central bank (Bangko Sentral ng Pilipinas). We suspect other central banks are thinking along similar lines and we may soon come across more anxiety in the coming weeks. But our concern is that the uncertainty for markets after the Fed finishes quantitative easing in October could trigger larger market volatility.

With India having received a large amount of portfolio inflows this year, governor Rajan’s comments are a subtle warning that the rupee could suddenly trade with much greater volatility should portfolio inflows reduce or if there is greater foreign exchange hedging of the underlying assets. In addition, India is still prone to running a current account deficit. Although the deficit has narrowed considerably over the past year, it still implies that the rupee is more exposed to the volatility of capital flows than some other Asian currencies.

Turbulent times ahead

This is even more the case, given that the structure of India’s capital account is largely a function of portfolio flows rather than foreign direct investment (FDI). If the latter contributed a much greater amount to the country’s capital account, then we would feel a little more relaxed, given that such funds are generally more long-term in nature. In contrast, portfolio flows can be very volatile and some investors can be quite fickle in terms of their willingness to stay invested in a particular asset class or country.

 

A bumpier ride

The rupee has lost ground considerably from its May high despite strong portfolio inflows 

The current pressure point for the rupee has less to do with a domestic story losing its sheen than with the external environment becoming more uncertain. Indeed, some of the inherent vulnerabilities behind the rupee are less acute than they used to be. But that does not mean that the rupee is completely out of harm’s way or that we should lose focus on what is happening domestically. 

Since the election, there has been closer scrutiny on the nature and pace of reforms that prime minister Narendra Modi would lay out, which could improve the rupee’s outlook and help boost long-term growth and curb inflation. The influx of portfolio flows suggests that the market has been confident that these structural reforms will come through eventually. However, there is a risk that the reform process starts to lose some momentum, and the capital inflow, which had supported the rupee earlier, then begins to dry up or in the worst case, actually reverses. 

What lies ahead

A combination of deterioration in the external environment and softening in reform expectations would pose downside risks to the rupee. The question would then be to what extent the RBI will step in to smoothen the rupee’s volatility. The central bank has built a more sizeable reserves buffer, which it could use to stymie potential US dollar strength whether arising, for example, from geopolitical risk or from the uncertainty surrounding the Fed. And, given the central bank’s ongoing focus on inflation, we would expect to see it take some action to ensure such exchange rate moves are not excessive. But we think that it is highly unlikely that the central bank would draw a line in the sand, especially if the dollar was strengthening against other currencies, too. 

So, the preference for exchange rate stability may not be as strong as it was last year, because it would be less of a rupee-specific story. Nevertheless, we still see the rupee ending 2014 at 60 versus the dollar. We do not believe the rupee should be considered the volatile animal that it once was as policy and confidence behind the currency are considerably higher than a year ago. But risks are rising that the rupee could be facing a bumpier ride in the coming months, given that some darker clouds are on the horizon.

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