The Curious Case of the Declining Rupee

 By Neelesh Agrawal

The crisis underway in China was recently earmarked with BoC’s second devaluation of the Yuan, this time by nearly two percentage points. The act, though targeted at revamping its own exports (which had fallen by 8.3% in Julyⁱ), led to havoc elsewhere – unvaryingly in both the emerging and developed economies. Most FII world over were prompted to reshuffle their emerging market portfolios mostly in favour of the stronger performing economies. Ideally one would expect India to be a strong candidate here, which according to a recent Reuters poll is still expected to grow at an annualized 7.4% for the April-June quarter¹ and has consistently shown improved macro fundamentals unlike most other emerging markets². But what occurred instead, was a sharp sell off by the FIIs (inclusive of stock exchanges & other primary markets) in the subsequent weeks as depicted below.
                                                       Fig 1: Movement of net FII investments post Yuan devaluation

A quick and perhaps an apparent argument for the sell off would be FIIs clubbing India with other emerging markets which unvaryingly saw an outward flow of investments. But India’s strong performance as against its emerging market peers is more than evident from MSCI India’s premium to MSCI EM widening to 65%, the maximum in the past 12 yearsⁱⁱ. The economy continued to outstand amongst the emerging ones as can also be deduced from the adjoining BCCL data (Table 1).  Moreover, the FII sell off elsewhere was accompanied by a sell off by domestic institutions, unlike in India where the DIIs went out of their way (Figure 2) and clocked the highest monthly investments in stocks in over six years³. The substantial rise in the net DII investments during August has been depicted below.

                                                    Table 1: India vs other Emerging markets (Source: BCCL4 ) 

What then would have prompted FIIs to behave the way they did?  We start by taking a look at different agents that were working globally and/or domestically against the Rupee during the period in case.                                                         Fig 2: Movement of net DII investments post Yuan devaluation

The mid-September meeting of the Federal Open Market Committee has been purported for months now, as the likely day for short-term interest rates to finally attain a positive value. So, it only makes sense that as the day approached, FIIs swiftly move their investments out of emerging markets including India. But as August unfolded, statements made by Larry Summers, Ray Dalio, Bill Dudley amongst others increasingly pointed towards lesser chance of a rate hike not just for this but even the next FOMC meet. This was in fact corroborated by the interest rate futures and options, wherein the former indicated just a 26% chance of a rate increase in the latter half of August, down from 50% at the start⁴.

As Summers brilliantly put it, none of the Fed’s major objectives namely price stability, full employment and financial stability warrant a tightening policy in September. This makes sense since more than 50% of components of the CPI declined in the last six months, for the first time in a decade making it difficult to achieve the two percent inflation target⁵. From an employment perspective, tightening would again make saving more attractive and also make US producers less competitive through a stronger Dollar, making no case for the same. Financial stability might have actually presented a case towards the start of the year when low borrowing rates encouraged investors to take higher risks through financial engineering, but the Chinese market massacre, correction in Dow Jones have already subdued any overconfidence in the markets suggesting no further need for a rate hike. So if anything, FIIs should have been prompted to ebb their Dollar investments in favour of stronger performing emerging currencies.

[su_pullquote align=”right”]After much debate, the Rajya Sabha ultimately closed the monsoon session without passing the GST bill. If we look closely, the first sharp downfall in net FII investments also occurred on the same day (Aug 13th).[/su_pullquote]

Let’s then turn towards the domestic line of events. By July, RBI had already cut repo rates thrice this calendar year by upto 75 bps but was accompanied by only a fractional decrease in lending rates by banks (30 bps) much to the frustration of corporates and the regulator. So Rajan decided to hold the rates for August while raising concern over slower transmission of previous cuts by the banks⁶. This was quickly followed by Rajan’s strong criticism of countries resorting to exchange rate depreciation post the Chinese devaluation. He further added that unlike others in the currency race, RBI would let the rupee find its own level and would only step in so as to curb volatility. This ideally should have signalled FIIs of absence of any imminent threat of depreciation of Rupee by the RBI and hence to the value of their Rupee investments (as was also inferred by analysts from Standard Chartered Plc and Barclays Plc⁷). But as is evident from the Figure 1 the FIIs continued to sell massively even after Rajan’s holding rates in the first week (of August) and the declaration of his stance on Rupee depreciation on 12th (August). So the massive sell off, at least in the first week post the devaluation, cannot be attributed to the central bank(er)’s actions.  Indeed one may very well be able to attribute the second cycle of FII sell off to Rajan, as he revealed his accommodative stance of a further rate cut contingent upon the macroeconomic data (primarily inflationary) at the Jackson Hole symposium. This does explain the second trough in Figure 1 that started materializing in the third week congruent with Rajan’s hinting at a fourth rate cut.

The analysis of FII sell off so far (particularly of the week of Yuan devaluation) thus makes it clear that the same cannot be attributed to the monetary policy or tightening elsewhere.  Moreover, our own monetary policies (and/or the central bank) had little/no role in the same. Data thus reveal that the often widely quoted reasons to blame FII outflows upon weren’t the ones that actually caused it this time. The reason can indeed be traced to something much more fundamental but has nonetheless been discussed the least- legislative/policy paralysis.

The week of Yuan devaluation happened to coincide with that of the closing session of the Parliament. After much debate, the Rajya Sabha ultimately closed the monsoon session without passing the GST bill. If we look closely, the first sharp downfall in net FII investments also occurred on the same day (Aug 13th). The washout of this session without the passage of the bill delivered a strong signal about the political system not being conducive to the business environment despite the favourable macroeconomic conditions. The bill was intended to replace a complex structure of federal and state taxes with the GST, which would have not only moved India towards a uniform tax regime but also protruded it as the place to be for global investors (particularly in the current chaotic times).

The inability of the NDA to convince the adamant opposition was thus a huge turnoff for the FIIs.

In fact, the event could very well be assumed to be the trigger that led to all subsequent outflows that continued throughout the month. As discussed earlier, the later sell off could also be attributed in part to the dovish stance put forth by Rajan at Jackson Hole. But it is highly dubious whether the outflow solely due to the latter would have been that enormous.

The recent activities, however, reflect that the policy makers have lately become cognizant of the fact. This can be seen in government’s decision to not subject FIIs retrospectively to the Minimum Alternate Tax before 1st April this year⁸. The move is subsequently expected to provide some support to the Indian markets, though policy makers still have a long way to go this year.

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Neelesh Agrawal is currently enrolled in the two year MBA course at the Indian Institute of Management, Bangalore. He interned with Goldman Sachs after his first year. He graduated from IIT Kharagpur, where he did a five year dual degree course in B.Tech-Civil Engineering & M.Tech-Financial Engineering (Rank 1). He holds two research publications to his credit as a lead author.