It's not economic strength but foreign inflows that's pushing the rupee

Foreign investors in March and April have turned unusually bullish on India

The recent strength in Indian rupee, about 5.5 per cent up against the dollar since January, could be a reflection of the growth in Indian economy, said Nirmala Sitharaman, minister of state (independent charge) for commerce and industry on Sunday. 

But it is important to gauge then if rupee’s strength is on a standalone basis -- or its trade partners and competitors, more specifically its Asian peers have also strengthened or not. Turns out that rupee is not the only one to strengthen rapidly against the dollar in the period. 

In fact, the rupee is not the highest gaining currency in Asia too. Excluding Japanese Yen, which is a major currency and also has appreciated the most in Asia, Taiwanese dollar has appreciated 6.39 per cent, South Korean Won has appreciated 6.28 per cent. 

At 11.50 am, rupee was trading at 64.3875, from its previous close of 64.41 a dollar. 

Year to date, rupee has strengthened 5.51 per cent, while the Thai Baht has moved 4.50 per cent up against the dollar. 

If we go by the real effective exchange rate (REER) of rupee on a 36 currency basket, the picture gets clearer. REER indicates the comparative value of rupee against its trade peers. Generally, rupee is always overvalued by 10-15 per cent. 

The REER at the end of March was 119.50, up from February level of 117.49. A year ago, the REER was 112.96. 

At the end of November, when demonetisation effect had hit the business sentiment of India, REER value was 117.46. 

This shows that strong domestic growth may not have much to do with the strength in Indian rupee. Rather, it is the continuation of quantitative easing money sloshing around in global markets, and getting parked in emerging markets debt and equity that are directly responsible for the rise in emerging market currencies, including that of rupee. 

Important to note here is that the US dollar itself is losing some of its value against major global currencies, or at best, holding to its present strength.

The dollar index, which measures the greenback’s strength against major global currencies, closed at 100.41, against its February end level of more than 102. 

In a recent report, Care Ratings argued that it is the inflows, rather than anything else, that has been driving the strength in Indian rupee. 

“The rupee will most definitely be driven by the FPI funding in the equity and debt markets as the other fundamentals are unlikely to change significantly. Assuming that these FPI funds continue to flow in the next 2-3 months the rupee will be fairly volatile but range bound between Rs 64-65/$ before moving back towards the 65-66 mark, which could be an equilibrium range,” wrote Care Ratings chief economist Madan Sadnavis. 

The foreign investors mostly remained on a sale drive on Indian markets in 2016. However, in March and April, they have turned unusually bullish. 

In March, a record $9.1 billion entered the markets in bonds and equity, out of which $5.1 billion went into the in the equity segment. Bond yields fell and equity indices rose sharply. 

That bullishness continues in April as well. So far this year, foreigners have bought $6.62 billion in equity and $6.48 billion in debt. 

Just as it flew in, the same flows can also reverse if geopolitical situation turns volatile and risk-averse situation grips the investors. Dollar will strengthen and the emerging market currencies will bleed, irrespective of the domestic strength of the local economy.