How India's rupee went from most to least volatile in Asia

The Indian rupee has gone from being one of Asia's most volatile currencies to among its most stable in the span of a decade.

The turnaround reflects India's growing economic heft and the central bank's interventions to manage the rupee's wild swings. With Indian bonds set to join an important global index this week, the currency's stability couldn't have come at a better time, burnishing the appeal of Indian assets for investors. Too much volatility makes it tough for businesses and investors as it could add to their costs. Here's a deeper look at how the rupee's fortunes have been transformed:

1. Why was the Indian rupee Asia's most volatile currency?

About a decade ago, India's inflation rate was around 10% — stoked in part by the government's decision to spend its way out of an economic slump that followed the global financial crisis — and crude oil, a key import, was trading at more than $100 a barrel. Frustration over political scandals and policy paralysis threatened to derail India's economic growth and its image as an investment destination. It all made for a toxic mix for investors, at just the wrong time, as the Federal Reserve's plan to reduce bond purchases in 2013 shook emerging markets. The prospect of Treasury yields moving higher brought a flood of investor cash out of developing countries like India back to the US at the time. The result was declining foreign-exchange reserves and a weaker local currency, placing India among the "Fragile Five" economies.

2. What tamed the rupee's wild swings?

The rupee continued to weaken against the dollar during Prime Minister Narendra Modi's rule over the past decade, but the swings became less wild over that period. Economic growth that beat most other nations, policy continuity and political stability — Modi remained in power after the most recent elections that concluded in early June — have drawn foreign investors. The government also implemented key reforms such as giving the central bank an inflation-target mandate and steadily whittling down the size of its budget deficit. So-called global capability centers are making India a hub for the export of services as varied as software and accounting. India now sits on top of the world's fourth-biggest pile of foreign reserves. The central bank has been buying dollars when the rupee is strong and selling foreign exchange when it weakens to lean against big moves in the currency. By managing the supply of dollars available in India's currency market, the Reserve Bank of India is able to smooth out shifts in the value of the rupee.

3. What does a less volatile currency mean for investors?

Indian assets provide relatively high volatility-adjusted returns — better performance with more predictability — compared with other emerging markets. The local currency is proving more reliable than those of economies in Latin America or Africa that might show a stellar performance in one year and burn a hole in portfolios the next. But there are shortcomings to the central bank's approach. Its firm grip means any changes in economic fundamentals may not always get fully reflected in the currency. For example, robust growth, which typically boosts a currency, might not necessarily make the rupee stronger if the RBI decides to buy more dollars in the market. Interventions by the central bank show that appreciation gets capped just as much as depreciation.

4. What does bond index inclusion mean for the rupee?

JPMorgan Chase & Co.'s decision to add the nation's debt to its flagship emerging-market index starting June 28 could bring fresh challenges for policymakers. A top finance ministry official said they are keeping all options on the table to deal with "hot money" flows. That refers to money from foreign investors that can enter and exit the country in large quantities at short notice, as opposed to foreign direct investment that typically goes into the construction of assets such as factories. Foreign investors have long been big buyers of Indian equities, but as they start to build a bigger presence in the bond market, it's an additional channel through which flows can buffet the rupee. The government will also have to run a tight ship, keeping any fiscal profligacy in check to avoid a knee-jerk reaction from investors. All else being equal, it's reasonable to expect that billions of dollars of inflows into Indian bonds would make the rupee stronger. But the RBI may prevent any extreme moves by adding to or drawing from its foreign reserves to preserve the currency's stability and India's export competitiveness. That means India's pile of reserves will probably build up even more, setting fresh records.

5. What more can be done to strengthen currency management?

The central bank is planning to upgrade its toolkit for foreign exchange market interventions, it said in its annual report, as it gears up for inflows stemming from its inclusion in the JPMorgan index. India is also striving to promote greater international use of its currency, particularly for trade. Investors will be watching for a pivot in monetary policy, as a softening of interest rates would add to downward pressure on the rupee. A narrower interest-rate gap with the US tends to weigh on emerging-market currencies, as investors find the relative value proposition less appealing.

6. How does the recent election result affect the rupee outlook?
Modi's Bharatiya Janata Party couldn't secure a majority in the recent elections, making him dependent on allies to form a coalition government. This set off concerns that the government could boost welfare spending at the cost of fiscal consolidation, which may negatively affect India's bonds. The rupee is still buoyed by foreign inflows to stocks and bonds, and may not see much impact.