Is something strange afoot in the rupee-dollar market, or am I just imagining things? The rupee continues to remain under pressure and apparently there is fairly heavy intervention by the Reserve Bank of India to stop it slipping past 54 to the dollar again.
Yet, if you ask any trader in a bank treasury, he is likely to tell you that there is hardly any shortage of dollars in the markets.
Thus, the momentum of the rupee doesn't seem to be driven by a large mismatch between the supply and demand for dollars. The only way to explain its frailty is to attribute it to weak sentiment, which keeps it offered.
One clear indication of this is the way forward premiums have behaved. As anyone who has taken a basic course in international economics would know, forward premiums reflect the difference in interest rates across economies whose currencies are involved.
Thus, the forward premium for the rupee is the difference between rupee interest rates and dollar interest rates - relevant, of course, to the tenure for which the premium is calculated.
One way to interpret a forward premium is as a gauge of the relative availability of rupees vis-a-vis dollars.
If rupees are abundant and dollars are in short supply, then rupee interest rates are likely to be low and dollar rates high, pulling forwards down.
In the extreme case, when there is a famine of dollars, forwards go into discount as traders seeking dollars offer the sky in terms of dollar interest rates relative to rupee interest rates.
In fact, our analysis of episodes of sharp depreciation since 2004 shows that they were preceded by periods of discount.
Yet, strangely enough, the current episode of depreciation that took the rupee to an unprecedented low was not preceded by a period of forward discounts.
Right through the period, forwards have kept rising. This would imply (if you are comfortable with my interpretation of forward rates) that the depreciation has taken place when rupee liquidity has actually been short relative to dollar liquidity - and not the other way round, as, theoretically, should have happened.
The other way to look at this conundrum is to try and map the relationship between dollar flows and the exchange rate and check whether the exchange rate is in line, or completely out of whack, with the balance of flows.
To do this, you could use the balance of payments deficit or surplus (published quarterly) and link it, as we did at HDFC Bank, to the rupee-dollar exchange rate through a formal statistical model.
The BoP is incidentally a summary of the inflows and outflows of dollars into the system for a period and the final balance reflects the excess
demand or supply of dollars.