RBI & The Indian Rupee

The fight between the Dollar and the Rupee… this is an extract (using AI) of a podcast by Deepak Shenoy.

Exchange Rate Fluctuations and Historical Context

• The Indian rupee has been weakening, and its exchange rate with the US dollar has been increasing, reaching 84 rupees per dollar, leading to concerns about the impact on expenses and investments denominated in dollars (00:00:07).
• Historically, the rupee has appreciated in the past, such as from 2005 to 2007, when it went from 43 to 39 rupees per dollar, despite the RBI's efforts to prevent appreciation (00:00:53).
• The exchange rate is influenced by inflation differentials between countries, with a 4% inflation differential between the US and India over the past 20 years, resulting in a 4% depreciation of the rupee per year (00:04:51).
• However, the actual inflation rates may be different from the reported numbers, with the US potentially underreporting its inflation and India overreporting its inflation, which could affect the exchange rate (00:07:04).
• If India's core inflation is lower than the US, the rupee should appreciate, contradicting the 4% depreciation per year (00:09:05).
• India initially had a fixed exchange rate after gaining independence, with the rupee pegged to the US dollar at a rate of 4.6, but this was later changed to 7.5 due to economic issues and wars (00:09:50).
• The country suffered from a lack of dollars and had to rely on foreign loans, which led to a famine in the 1960s, prompting India to develop its Green Revolution to become self-sufficient in food production (00:11:34).

RBI's Role and Influence on Exchange Rate

• The Reserve Bank of India (RBI) plays a significant role in determining the exchange rate by participating in the Forex Market, buying and selling dollars, and printing rupees to maintain a stable exchange rate (00:14:06).
• The RBI's presence in the Forex Market helps stabilize the rupee and prevents it from weakening dramatically, which would lead to people moving their money abroad and investing in foreign assets (00:15:59).

India's Current Account Deficit and Investment Flows

• India's current account deficit is influenced by three main factors: imports and exports, remittances from Indian people living abroad, and foreign investment (00:17:49).
• India's current account deficit has narrowed down considerably in the last 4-5 years, with remittances playing a significant role, totaling around $100 billion a year (00:18:29).
• Foreign investments into India, including Foreign direct investment and FPI, have been substantial, adding up to around $216 billion from 2000 to 2024 (00:21:13).
• The RBI's intervention in the Forex market by buying dollars and giving rupees has led to a depreciation of the rupee, despite net inflows of dollars (00:21:31).
• Not all foreign inflows are created equal, with some being short-term and potentially reversible, such as investments in the stock market (00:22:31).
• The freedom to take money out of India has increased, with companies like Hyundai Motor Company listing in India, and Indian companies reverse-investing in the US (00:24:54).
• Investment flows may not be permanent but are unlikely to be one-directional over a long period, with mispricing being corrected by new investors (00:25:25).
• The Liberalized Remittance Scheme (LRS) limit is not being fulfilled by investments abroad, and the Reserve Bank of India could consider opening it up as it doesn't matter if people invest abroad if India is growing at 10-15% a year on stock markets (00:27:31).

Factors Affecting India's Trade Balance

• India's imports are price insensitive, with 12 billion out of the 25 billion trade deficit being crude oil imports and 8 billion being gold imports, which are not affected by price changes (00:29:13).
• The RBI looks at exports rather than imports, and a weaker currency can make exports stronger, but non-tariff barriers and the government's introduction of tariffs can affect this (00:30:01).

Real Effective Exchange Rate and Rupee Valuation

• The Reserve Bank of India uses the Effective exchange rate (REER) to measure the rupee's strength, but this metric is flawed as it doesn't consider services and invisibles, which are significant in India's trade (00:33:02).
• The rupee's value doesn't make sense, as $216 billion came in, and the current account deficit was $120 billion, yet the rupee went from 70 to 84, and the fear of flows going out is not a concern as India can't pay back the trillion dollars owned by foreigners in the public markets (00:34:31).

RBI's Intervention, Inflation, and Forex Market Dynamics

• When the RBI buys dollars, it has to print rupees, which can lead to negative consequences, and this was seen in 2004-2007 when the rupee appreciated, and there was a massive inflow of dollars (00:36:04).
• The RBI prints more rupees to buy dollars, which can create inflation, especially when the banking system is starved of money and credit growth is high, with credit growth reaching 25-26% per year around 2007 (00:36:53).
• To control inflation, the Reserve Bank of India takes excess rupees out of circulation by paying interest on them, which is funded by the government through dollar stabilization bonds, ultimately paid by taxpayers (00:39:16).
• The RBI's participation in the Forex market has been significant, especially in the last 5 years, with the goal of controlling the rupee's movement, but this can also fuel inflation (00:40:42).
• The RBI's actions are influenced by the Foreign Exchange Management Act (Federal Emergency Management Agency), which gives the RBI power to control foreign exchange and frame laws, allowing it to take measures to control the rupee-dollar equation (00:43:48).
• If the RBI were to stop intervening in the Forex market, there could be an outflow of dollars, and the rupee might fluctuate more freely, reflecting economic realities (00:45:28).

India's Growth Potential and Investment Opportunities

• India has more growth potential than the US, and people abroad are willing to invest in India, which could lead to appreciation of the Rupee rather than depreciation (00:45:57).
• India's exports are mostly commodity-based and can be easily replaced, but some Indian brands like Haldiram's have a strong global presence and are not price-sensitive (00:46:09).
• A freely floating Rupee would allow Indian people to own more foreign assets, and the RBI's current restrictions on investing in foreign stocks are limiting this potential (00:49:09).

RBI's Conservatism and its Cost

• The RBI's conservativism in managing the Rupee may be seen as a form of insurance, but it comes at a substantial cost, equivalent to 1-3% of India's GDP, and the profits generated by the Reserve Bank of India are not distributed to the people (00:53:27).
• The RBI's accounting policy change has led to a significant increase in dividend payments to the government, from 60,000 crores to 200-300,000 crores, but the RBI still retains 22 lakh crores in profits, which is more than India's current account deficit and fiscal government deficits (00:55:37).
• The RBI's control of the rupee has generated profits and created a bloated balance sheet, but these profits should be paid out to the government to reduce deficits and interest payments (00:56:24).

Investment Recommendations and Rupee's Natural Tendency

• As an investor, it is recommended to invest in foreign stocks to take advantage of innovation abroad, particularly in the US, China, and Europe, and to diversify one's portfolio (00:58:26).
• The rupee's natural tendency is to appreciate due to lower inflation in India, driven by increased manufacturing and logistics efficiency, while the US has a slowing economy and high inflation (01:02:16).
• The RBI's efforts to artificially inflate the dollar may be countered by investing in the rupee, which is naturally getting stronger, similar to George Soros' bet against the Bank of England in 1992 (01:03:09).

Speculation, NDF Market, and RBI's Position

• However, completely opening up the rupee to speculative trading may create volatility and speculation, which could move in ways that have no reflection of economic realities (01:03:42).
• India has more inflows than outflows overall, and the country has stopped speculation due to Federal Emergency Management Agency regulations, which led to the creation of a non-deliverable forward (NDF) market in London (01:04:06).
• The Reserve Bank of India has set up a $50 billion short position in the NDF market, which has raised concerns, but the RBI's potential losses are relatively small, around $1.2 billion if the rupee weakens (01:08:01).
• The RBI's participation in the NDF market is seen as a way to control speculation and protect the rupee, but it's argued that allowing speculation to happen in India would create a wider market and reduce the RBI's burden (01:10:47).