Between March 18 and 29 -- in eight trading sessions -- the rupee gained close to 3 per cent against the dollar (from 45.24 to 44.04).
This does not happen too often in the currency markets. In fiscal 2003-04, the rupee appreciated about 9 per cent against the dollar, its highest annual gain. On April 1 last year, the rupee was trading at 47.40.
The rupee's day out started on March 19, when it rose by eight paise -- from 45.24 to 45.16. At the next trading session (March 22), it went up to 45.07 and it pierced the 45 level once (March 23). In five days, its value zoomed to 44.04 per dollar. (At the time of writing this piece on Wednesday, the rupee strengthened to touch 43.40.)
The Reserve Bank of India, which had been defending the rupee at the 45.25 level since the end of January through aggressive intervention by several public sector banks, watched the show from the sidelines.
Between January 30 and March 19, the country's foreign exchange reserves went up by $5 billion (from $104.998 billion to $109.998 billion).
In other words, the RBI mopped up $5 billion from the market to arrest the appreciation of the rupee and keep the Indian unit at 45.25 during this time.
So what exactly happened in these five days that triggered a free fall for the greenback? Does it signify a change in the RBI's policy stance? Will the central bank stop intervening in the foreign exchange market and allow the rupee to find its own level? Will we see the rupee touching 42 over the next few weeks?
Before looking for answers to these questions, let's hear what RBI Governor Y V Reddy has to say. There was no formal announcement by the RBI on the sudden rise of the rupee, but Reddy answered journalists' queries on the sidelines of two functions last week.
First, he said the central bank's foreign exchange policy was to allow a market-driven exchange rate and it did not have a target for the rupee.
He also said that one should not try to link exchange rate with inflationary pressure as "exchange rate is based on demand and supply and all we try to do is to ensure that there is not much volatility".
Finally, Reddy also pointed out that the movement of the rupee is being influenced by global currency movements and those have been relatively stable.
No one would argue with two of these statements. But surely a 3 per cent rise in the value of the rupee in eight trading sessions is a sign of volatility. So why didn't the RBI intervene?
There are three theories doing the rounds.
First, the central bank's abstinence is triggered by the fact that it does not want to subsidise the foreign institutional investors who have invested heavily in the public floats of ONGC, Gail India, CMC, IPCL and Dredging Corporation of India. In ONGC alone, investment by FIIs could be close to $ 1 billion. All this money flowed into India within a span of a week or so.
Now, had the rupee been kept at its mid-March level of 45.25, the FIIs would have required to bring in less dollars to pick up their quota of allotment in the public sector divestment programme. So, the RBI has allowed the rupee to strengthen. As a result of this, the FIIs needed to pump in more dollars.
This hypothesis may not, however, be entirely correct because FII inflows have been quite heavy all along and the central bank never thought of allowing the rupee to find its own level and stop subsidising FIIs before.
Besides, by keeping the rupee at an artificially-low level, it has been subsiding exporters too. Why should it suddenly change the stance? Nobody knows the answer.
Another possible explanation for the RBI's lack of intervention is the erosion of the stock of government securities in its kitty to continue with the sterilisation exercise.
Normally, some of the big public sector banks -- like State Bank of India, Bank of Baroda, Bank of India, Punjab National Bank and Canara Bank -- buy dollars from the market on behalf of the central bank.
This dollar-buying swells the country's forex reserves and stems the rupee appreciation. For every dollar bought, an equivalent amount of rupees enters the system.
At the second stage, the RBI drains the rupee liquidity from the system by selling securities in its stock through the repurchase or repo window. The sterilisation exercise, which has been on for over a year, is rapidly depleting the RBI's stock of gilts.
Going by the RBI's weekly statistical supplement data, on March 19, the stock was as low as Rs 23,318 crore (Rs 233.18 billion). In other words, theoretically, at best, the RBI could sterilise another $5 billion or so.
The RBI has about Rs 90,000 crore (Rs 900 billion) worth of government securities at its disposal to carry out its liquidity management. However, about Rs 60,000 crore (Rs 600 billion) or so of this has continuously been used for its repo operations.
The average daily outgo through the one-day repo route in March has been around Rs 50,000 crore (Rs 500 billion). Add to that the money sucked out through the 14-day repo window. The outstanding repo on any given day would be around Rs 60,000 crore (Rs 600 billion).
So, it is left with little headroom for the sterilisation exercise since ideally, part of the stock should be kept for conducting open market operations (OMO) to suck out excess liquidity if the need arises.
However, the scenario will change because the RBI has already signed a memorandum of understanding with the Centre to float new securities under the market stabilisation scheme (MSS). The government will float Rs 35,500 crore (Rs 355 billion) worth of securities in the first quarter of 2004-05 under this scheme.
All these papers will be used for the sterilisation exercise. The first issue, a Rs 5,000 crore (Rs 50 billion) tranche of short term one- or two-year paper, will hit the market in the first week of April.
In fact, in April, Rs 18,000 crore (Rs 180 billion) worth of MSS papers will be floated. This will enable the RBI to mop up about $4 billion from the foreign exchange market if it decides to start intervening.
Does that mean that the days of RBI intervention in the forex market will be back in April? Will the rupee appreciation suddenly halt now? This brings us to the third hypothesis. The rupee may continue to appreciate because the RBI has radically changed its strategy.
The RBI has so far been balancing two variables: export competitiveness and imported inflation. As the rupee appreciates, exporters' profits will drop but the profits of domestic companies will go up since the cost of imported inputs would go down.
With global trade representing only about 25 per cent of India's gross domestic product (GDP) -- against about 50 per cent in China and 65 per cent in Korea -- the impact of a stronger rupee may be limited, says a UK-based investment bank's report released last week immediately after the rupee pierced the 45 level.
Even though the wholesale price index-based inflation rate has come down to 4.78 (on March 13), it is bound to go up once the base effect wears off.
The investment bank has cited three reasons for this: a continuous rise in global commodity and energy prices (cost-push inflation), strong growth in domestic demand (demand-pull inflation) and higher-than-projected growth in money supply.
The best way to contain inflation at this point of time is allowing the domestic currency to appreciate. This will address three important issues: limit cost-push inflation through its impact on imported prices, slow the growth in forex reserves as well as money supply.
Shorn of technicalities, a stronger rupee will bring down the import bill despite the hike in international commodity and energy prices. For instance, the price of imported crude has gone up from $31 per barrel to around $35 over the last few weeks but the domestic oil companies have not raised the price of petrol and diesel, since elections are round the corner and any hike will impact inflation.
However, after the new government is sworn in, these companies are bound to raise prices. But with the rupee gaining in strength by the day, their import bill would not be as high as it would have otherwise have been on account of the crude price hike.
In other words, the RBI's objective is clearly to prevent an acceleration of inflation and nurture investment recovery. It is another matter that the central bank refuses to admit this.