Rupee risk for USD Denominated Investors

There is an inherent familiarity bias in investing. As an NRI there is an inherent comfort in parking hard earned savings in the form of a term deposit with SBI or investing in a debt fund that primarily invests in Indian government securities. The million dollar question for every dollar (or any other FC) denominated investor is – what will be my currency adjusted returns. I.e. How much will I make in dollar terms after factoring in any potential INR depreciation.

Let’s look at some historical numbers to help with the analysis.

Date of Investment1-Oct-181-Nov-161-Aug-132-Mar-09
Date of Sale of Investment12-Dec-2012-Dec-2012-Dec-2012-Dec-20
Investment Period in Years2.24.17.411.8
SBI FD Annual Interest6.00%7.00%8.75%8.50%
Net Return Cumulative12.11%22.89%70.41%82.26%
Net Return Annualized5.33%5.14%7.50%5.22%

If you just look at all these periods under consideration, it seems like almost a slam dunk of an investment. Let’s look at some more periods in recent history.

Date of Investment3-Jun-191-Jan-181-Apr-131-Jan-08
Date of Sale12-Dec-2012-Dec-2012-Dec-2012-Dec-20
Investment Period in Years1.52.97.713.0
SBI FD Annual Interest6.75%6.25%8.50%8.50%
Net Return Cumulative-5.63%-0.11%35.37%45.40%
Net Return Annualized-3.72%-0.04%4.01%2.93%

Well, the slam dunk of an investment does not look quite attractive now. While the oft used phrase of “Don’t time the market and instead spend time in the market” is absolutely true, getting the timing wrong does have some real monetary implications for the investor.

The importance of exchange rate considerations in INR denominated asset investment brings me to the main topic of the note – the trilemma of international economics. Mundells masterpiece from the sixties, much poured over in economic forums and informal conversations alike. The trilemma in simple words means that a country cannot choose to have all three of the following – an independent monetary authority (free from international influences) a fixed exchange rate and no restrictions on cross border movement of capital. Take the example of the US. The US has a completely flexible exchange rate which means it is truly determined by market forces. It hence has an independent monetary authority and no capital controls. To some extent the European nations were in a similar boat till the introduction of the Euro when the participating countries gave up control over monetary policy in exchange for a fixed exchange rate system – in this case the Euro. Emerging markets like India and China have a bit of a mixed approach to managing this trilemma. One that involves partially restricting the free movement of capital and managed floating rate regimes for their exchange rates. India has followed a gradual path of financial integration with the world, inching gradually on capital account liberalisation. Yet for a populous, still significantly agrarian and still developing economy like India, especially from a political viewpoint, losing control over monetary policy independence is a complete no go, in my opinion. Yet empirical evidence over the past few decades actually shows that India managed to achieve a fair bit of financial integration and stability in currency while still not giving up too much of monetary policy independence. Which brings me to the fourth aspect of the trilemma and the conclusive point of the note – FX reserves and more importantly the sheer power of messaging. India’s FX reserves now stand at 574B or 20% of GDP (based on 2019 GDP) a far cry from the troubled days of March 91 when the figure was just 5.8B or even 2013 when FX reserves were at a low of 275B or less than 7 months of imports. The sheer size allows India to breathe easy for periods in the future when the currency would come under pressure from risk events leading to portfolio outflows from India. If you take this view, investing in INR assets for a higher yield than what you are likely to receive in your home country seems worth the risk.

Just elaborating on the Trilemma in India’s context and the strength of the FX reserves a bit more. For those who would like to read more on the topic, I have provided below a link to a summary paper (Michael Hutchinson, Rajeshwari Sengupta and Nirvikar Singh). The paper addresses the Trilemma in the Indian context providing a view on how greater financial integration has put more constraints on exchange rate and monetary policy. For those who want to dig even deeper, MRN have essentially used a methodology developed by Aizenman, Chinn and Ito (link below). In simplified language that’s easy for the reader to understand the Economists design indices using certain parameters to measure each of the 3 aspects of the Trilemma. For instance monetary policy independence is assessed using the inverse of the correlation between the interest rates in India and the interest rates in the United States. Obviously if the correlation is low, then the inverse of the correlation will be high and a higher index value signifies greater monetary independence. One of the observations of the MRN paper in summary shows that exchange rate stability has been a policy priority for India. The paper also examines the reserve accumulation aspect in the context of the trilemma. The accumulation of FX reserves has given policy makers in India more flexibility in dealing with the short term trade-offs between monetary policy independence and exchange rate stability as it continues its financial integration with the outside world. There are 2 more observations in the MRN paper. Their empirical evidence suggests that the increase in financial integration and exchange rate stability resulting in the loss of monetary independence is correlated with higher inflation in India. Second the exchange rate stability on account of the Policy measures has benefited in reducing inflation volatility.

In any case the key takeaway for me remains the prioritization of exchange rate stability and importance of reserve accumulation in providing more leeway for policy manoeuvring.

Now there is another facet to this story and that is a line of thought that India’s FX reserves are more than required currently and that they can be utilized towards better purposes like spending domestically on infrastructure. How this alternative line of thought evolves will have a bearing on the Trilemma in the Indian context and India’s future policy alternatives.

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