Global financial market evolution, the carry trade and India’s economic ascent
Key takeaways
One of the most impressive changes to the global economy is the ascent of India. Its economy has doubled to $4 trillion over the past decade, and it’s becoming a major player in the international economy.
India has the fifth-largest stock market, and its $1.3 trillion sovereign debt market is the darling of global and institutional investors looking for solid fixed-income returns—they are using its stable currency, the rupee, as the source of a lucrative carry trade across the $7.5 trillion per day churn in global capital markets.
The rupee has been relatively stable against the dollar this year, falling from 82.35 at the outset of the year to a low of 83.9 in the first weeks of August.
Forward pricing as of Aug. 23 implies the rupee will flatten out through the end of the year before depreciating further to 95.6 over the next five years. Such a move would mean a 14% depreciation in the value of the rupee at a pace of 2.6% per year.
As long as the Reserve Bank of India remains committed to intervening in currency markets to stabilize the rupee, investors will continue to use the rupee as the basis of a global carry trade that bolsters dollar-denominated assets in the U.S. and other economies.
In fact, J.P. Morgan is now set to include Indian fixed-income assets into its emerging market global bond index, which will surely stimulate demand for rupee-denominated assets.
The carry trade is a foreign exchange strategy that focuses on borrowing at a low interest rate in one country and then investing those funds in an asset elsewhere for a higher rate of return.
Traditionally, this involves borrowing in a low-interest-rate currency and transforming that quantity into another currency. For the past three decades or so this has been one of the more popular trading and hedging strategies organized around the yen-dollar carry trade.
Once the funds are exchanged into the bilateral pair—for example, borrowing in yen and purchasing the U.S. dollar—they are used to purchase bonds, commodities, equities or real estate.
Today, investors around the world are seeking to do the same with the rupee-dollar bilateral pair.
The one-month implied volatility of the rupee-dollar—a measure of the expected volatility of the underlying asset between now and the option maturity date—is 3.55, which explains why.
This compares favorably with regional peers like the Chinese, Thai, Korean and Philippine currencies. That return is why the rupee is the favored regional carry trade against other local currencies even as the rupee has modestly depreciated against the dollar this year.
Over time, as the Indian economy grows and expands into the lucrative provision of global economic services as opposed to manufacturing, demand for rupees will expand, testing the Reserve Bank of India’s commitment to keeping the rupee undervalued.
For now, however, the quickly changing structure of the global economy favors the rupee-dollar carry trade as well as purchases of the rupee versus other regional currencies.