Discussion of ‘Indian rupee market intervention:Managing FX volatility or inducing additional capital

inflows?’ by Hiroko Oura

Ila Patnaik

October 1, 2008

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 1 / 20

Main argument of the paper

Two dimensions to currency pegging: sustaining a distortedexchange rate and reducing currency volatilityMainstream view: exchange rate distortions are bad, reducingcurrency volatility is not so badPaper finds that the reduction in INR/USD volatility helped induceincreased capital flows into IndiaLowering currency volatility has a costAn important and new idea.

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 2 / 20

Part I

Main contribution

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 3 / 20

Returns

Interest rate differentials measure returns.Interest rate differenticals alone do not explain capital flows toIndia.

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 4 / 20

Has the spread influenced RBI intervention?

12

34

56

7

Per

cent

age

poin

ts

2000 2002 2004 2006 2008

IN.3m − US.3m

2000 2002 2004 2006 2008

The missing ingredient: Risk!

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 5 / 20

Part II

Is there loss of monetary policy autonomy under apegged exchange rate?

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 6 / 20

Shades of gray of the impossible trinity

At the corner: fixed exchange rate + open capital account. We’repretty certain there is no monetary policy autonomy.What about shades of gray? Low exchange rate flexibility is notthe same as fixed exchange rate.Emerging intuition: there is a smooth progression into loss of MPautonomy as currency flexibility goes downAnnualised INR/USD volatility of below 5% is not that differentfrom a fixed exchange rate.

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 7 / 20

Mechanism for loss of MP autonomy

MP autonomy requires the ability to have a short rate differentfrom the USPaper emphasises the profits from the ‘carry trade’ : borrow in theUS, buy Indian treasuries, do no currency hedging.Reward = US.3m - IN.3m + INR.appreciationRisk = INR/USD volPaper says: Look at the Sharpe’s ratio of this trader =Reward/RiskLower currency volatility drives up SR.Reduced exchange rate flexibility→ increased attraction for thecarry trade→ more capital comes in→ loss of MP autonomy.

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 8 / 20

Yen carry trade vs. dollar carry trade

For dollar peggers like India, the yen carry trade has limitedattraction since INR/JPY is a floatBut when the US cuts rates, the dollar carry trade is a seriousproblem.Contrast between US cutting rates vs. India facing high inflation.INR/USD volatility is the key in shaping the choice of the carrytrader.

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 9 / 20

Part III

Supporting evidence

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 10 / 20

Fine structure of the INR/USD pegged exchange rateregime

Four sub-periods of the Indian exchange rate regime (Zeileis, Shah,Patnaik, presented in 1st research meeting):

05

1015

2025

Squ

ared

wee

kly

perc

enta

ge c

hang

es

1995 2000 2005

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 11 / 20

The behaviour of firms across these regime changes

1 Exchange rate flexibility was low-high-low-high. Unhedgedcurrency exposure did the same (Patnaik and Shah, presented in1st research meeting)

2 In the 4th period, 93 out of 126 industry indexes were betting onappreciation (Patnaik and Shah, presented in this researchmeeting)

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 12 / 20

Part IV

Suggestions

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 13 / 20

Suggestions

Time series models of currency volatility can be used asalternatives to the implied volatility from the OTC currency optionsmarket which has data only from 2004.The Moody’s Baa spread can be used instead of the tbill rate asthe relevant rate for private borrowers from emerging economies.Currency expectations are likely to play a role as well in expectedreturns from carry trade. These can be modelled using CIPdeviation.Monthly FDI+FII data, even though not explicitly debt, should alsobe analysed similarly.

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 14 / 20

Three interest rates

24

68

10

Per

cent

2000 2002 2004 2006 2008

IN 3mUS 3mUS Baa

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 15 / 20

Two spreads of interest

−2

02

46

Per

cent

age

poin

ts

2000 2002 2004 2006 2008

Off USTOff US Baa

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 16 / 20

A technical detail: option implied volatility

The INR/USD currency option market is OTC and illiquidIt is a weak series and it limits the span of the datasetAlternative strategy:

1 Compute the intra-month vol of each month2 Estimate ARMA models of this series3 Use information at time t to make three forecasts4 Average this

This is roughly what an intelligent human would do.

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 17 / 20

Forecasted INR/USD volatility

12

34

5

Vol

atili

ty fo

reca

st (

annu

alis

ed)

2000 2002 2004 2006 2008

AR(5)ARMA(1,1)

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 18 / 20

Measurement of currency expectations

Covered Interest Parity arbitrage in India is blocked by capitalcontrolsCIP Deviation is hence an interesting measure of currencyexpectations (Patnaik and Shah, 2006).This can be used as a measure of expected change of INR/USDexchange rate.

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 19 / 20

Extend beyond debt flowsMonthly data is available for FII and FDI flows.

−1.

0−

0.5

0.0

0.5

1.0

a$flo

w.p

c.gd

p

2000 2002 2004 2006 2008

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 20 / 20

Explaining investment flows

Robust regression using data from Feb 2000 to Jul 2008:

Parameter Coefficient t statisticIntercept 0.8181 1.743VIX -0.0375 -3.094Baa spread 0.1371 3.386SR for CIP Devn 0.1828 2.043

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 21 / 20

Part V

In summary

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 22 / 20

Summary

The paper makes a new and important contribution to theliterature on exchange rate management.The key result of the paper is that lowering exchange rate volatilityis seen to have increased capital inflows into India.There is other supporting evidence for the key result of the paper.Some suggestions to expand the scope of the study.

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 23 / 20

Thank you.

Ila Patnaik () Discussion of ‘Indian rupee market intervention: Managing FX volatility or inducing additional capital inflows?’ by Hiroko OuraOctober 1, 2008 24 / 20