Sentiment, The Real Reason Why Rupee’s Fall Isn’t Stopping

First they said it would stabilise at 68. Then at 70. Definitely around 72.50. But the Indian rupee has defied all those short-term targets and is now trading at near 73 against the US dollar.

Some statistics for context: The rupee is down more than 12 percent this year. It has depreciated more than five percent in a month. In the last five days, the rupee has depreciated 1.57 percent.

Turkey, where the trouble was acute till a month ago, has seen its currency gain by 2.7 percent over this five-day period. But the Indian rupee has continued to depreciate.

On Wednesday, it hit a low of 72.91 against the dollar.

The currency weakness has filtered through into the bond and equity markets. In the bond markets, the 10-year yield has jumped to 8.22 percent on the fear of interest rate hikes.

So what’s going on? And where does the fall stop?

Market veterans say that putting near-term targets on the rupee is pointless for now. The rupee is trading on momentum at the moment, so it’s tough to say where it will stop in the near-term, said Jayesh Mehta, treasurer at Bank of America-Merrill Lynch. There is no attempt seen to break the fall and so speculators are emboldened to continue taking long-dollar positions, implying a weaker rupee, Mehta explained.

To be sure, a number of fundamental factors have backed the weakness in the rupee this year. Be it higher oil prices, a wider ex-oil, ex-gold trade deficit, the capital outflows and the global sell-off across emerging market currencies.

All those factors explained the initial fall.

But the most recent leg of the rupee fall seems to be more about the sentiment than the fundamentals.

Yes, the sentiment has been shaped by the fundamentals but also by the view that the central bank is not stepping in to support the currency even though it can.

B Prasanna, head of global markets at ICICI Bank, shared that view. While the Reserve Bank of India intervened quite successfully between the 69 and 70 per dollar levels, their intervention has been limited since then, he told BloombergQuint in an interview. They have $400 billion in reserves so they can choose to intervene if they want, Prasanna said.

The view that the RBI is taking a hands-off approach to the currency fall has taken hold in the market. Japanese brokerage Nomura, in a note last week, suggested that the regulatory approach to the currency fall is one factor that could bring the rupee down further.

Core Flows Versus Sentiment Flows

Ananth Narayan, associate professor of finance at SP Jain Institute of Management and Research and a veteran of the financial markets in India, makes another key point to explain the current fall.

There are two different set of fund flows, he explains. There are ‘core’ capital flows which are sensitive to fundamentals like the current account deficit, etc. And then there are flows related to sentiment.

By letting the rupee fall at such a sharp pace, you risk the sentiment going negative and that leads to sentiment-related outflows.

You don’t want to risk opening the ‘floodgates’, he cautioned. Ananth pointed out that in the last few days, conditions in the non-deliverable forwards market have also turned adverse, suggesting the mood among offshore participants is also changing.

Beyond all else, the change in direction of flows is the real reason behind the rupee’s fall, said Mehta as well.

For the calendar year-to-date, India has seen Rs 47,891 crore in foreign outflows. Of this Rs 43,560 crore in outflows have come from the debt markets. Last year, in 2017, India saw foreign inflows of Rs 2 lakh crore, of which Rs 1.48 lakh crore came into the debt markets.

That is the key problem, said Mehta.

A Word Of Advice From A Former Governor

No one will argue that the RBI does not have options to stem the fall in the currency markets.

First, the RBI has used no verbal intervention so far. The words of the central bank can shift signals in the market. Then there is the $400 billion in reserves, which cover more than nine months of imports. Just the quantum of reserves gives the RBI significant firepower.

There are other tried and tested options like opening a window for oil companies to buy dollars. There is the option of tapping non-resident Indians again, although a number of experts are cautioning about such frequent outings to tap non-resident Indian deposits. Finally, the extreme option of the interest rate defence .

Former RBI Governor YV Reddy in a recent conversation on the 10-year anniversary of the collapse of Lehman Brothers, cautioned against letting the market believe that depreciation is due.

You should never allow the markets to have a dominant feeling that some depreciation is required. The expectation should be more appreciation than depreciation. If the depreciation is forced by the market... you should handle the sentiment when it starts and not when it fully expresses.  

YV Reddy, Former Governor, RBI

“The way I look at it is don’t allow the sentiment of depreciation to rise too much. Even as it starts, you must do something. What you want to do, what package you want to use, what communication, etc., you can decide. But the sentiment in the market is important,” Reddy added. He went on to add that once the depreciation begins, the central bank should only act when it is confident that the intervention will work.

(This article was originally published on BloombergQuint.)