Market Maniac

The Anomalous Strength of the Rupee
Jan 23, 2012

Ever since RBI pulled down the gates on long USD positions by banks on December 15, and more particularly after the year turned, the rupee has been acting strangely. Not content with simply strengthening when the dollar is weak, it has been putting on a kick even when the dollar is strong – behaving quite anomalously, I thought.

That word – anomalous – took me back to seventh or eighth standard physics and the Anomalous Expansion of Water. I remembered that water (like all fluids) expands as its temperature rises and contracts as its temperature falls. However, when its temperature reaches 4◦ C, it shifts gears and, in apparent contravention of laws of physics, expands on further falls in temperature.

I spoke with my son – he is closer in time to the seventh standard and, in any case, has a far greater facility with understanding physical phenomena – who explained that this is how fish are able to survive in even the harshest of winters.

As air temperature falls, the water at the surface of the lake gets colder; the cold water, being heavier, sinks and warmer water from the bottom rises to the top. This continues cooling the entire water body, till the air temperature reaches 4◦ C. After this, the anomalous expansion results in colder water getting lighter and remaining at the surface. Thus, even when the surface water reaches 0◦ C and freezes, the water in the lake remains warmer – between 4◦ C and 0◦ C – and the little fishy-wishys can continue to swim and survive.

A wonderful trick from God.

The central bank, according to a wise man of the market (my father), should be like God – you know she is always there but you never see her till there is an emergency.

And an emergency it certainly was last December. At 54+ to the dollar, many companies were in danger of freezing over – indeed, some would say, 54 was already below 0◦C. Playing God, as it should, RBI waved its magic wand.

And, sure enough, the rupee froze at 54+.

Then, it started strengthening, slowly at first, then suddenly and more rapidly, unbothered by otherwise “important” forces, like the dollar’s behavior overseas, the continuing European confusion or the overhang of our current account and budget deficits. Like water when it gets too cold, the rupee started behaving anomalously.

Interestingly, the price action since then has brought the rupee broadly back to the level it was in July/August this year relative to the Euro – i.e., EUR/INR is at more or less the same level it was six months ago. In other words, the dramatic “excess” depreciation the rupee experienced against the dollar between September and December has been reversed. With the dollar index at 81 as opposed to 74, it is perfectly reasonable that the rupee should be at 50 rather than 45.

Indeed, over the past few days, the rupee, at 50, appears to have reached its current limit of strength – its 4◦ C, in a manner of speaking – and the little fishy-wishys appear to be surviving.

In supplication to the good wishes (a nearly 8% gift) of the Lord, importers should hedge some part of their risk now.

So, where do we go from here? In particular, when does RBI lift the curbs on the market?

Following the analogy, it should not let the ambient water fall below 0◦ C (54+), and relax only when the surface temperature rises sustainably.

This can happen in two ways: first, the dollar goes into another real swoon overseas – say, it falls below 1.35 to the Euro and US economic statistics take a substantial turn for the worse. To my mind this is unlikely – another one of God’s wishes is that Obama gets re-elected and that can only happen if US figures continue to improve.

Further, my special personal Mecklai ‘Merican Economy thermometer is signaling stronger growth ahead. Regular readers may recall that I often speak of a close friend who has a small business in the US, designing, manufacturing (in India, Thailand, etc.) and distributing the most wonderful household goodies – embroidered pillows, dishtowels, glasses – all sporting his extraordinary designs. Wonderful, as I said, but not particularly cheap (the pillows retail of $ 150), and certainly highly discretionary.

Last week he told me that business in 2011 was up 22% on 2010; better than that, his sales at the largest trade show of the year, held in January, were up 38% on last year.

Forget about US QE – hedge your LIBOR risk.

The only other way the surface temperature can climb is if/when inflows into India start to accelerate – we may are seeing the beginning of this. The best thermometer, of course, is the level of reserves. Thus, I believe RBI will only lift the restrictions on the market when the reserves once again cross $ 320 billion.

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