Rajeev Malik & Siddharth Mathur: The rupee in 2005

The Reserve Bank of India (RBI) faces a challenging task in managing the exchange rate this year, owing to opposing forces that will affect the outlook for the Indian rupee. This article analyses the impact of these forces and concludes that the RBI will continue to intervene in the forex market to check any meaningful appreciation of the rupee against the dollar in the near term.

Indeed, it will probably prefer a slightly weaker exchange rate later in the year. Thus, the rupee is likely to be a relative underperformer among Asian currencies poised to strengthen on the back of a revaluation of the Chinese yuan.

There are three main negative factors hurting the rupee, including a deteriorating balance of payments:

India posted its second consecutive deficit on the current account in the quarter ended December. Higher global oil prices, strong growth in non-oil imports owing to buoyant domestic demand, and defence imports were the key drivers of the worsening trade balance. The pace of increase in the "invisible" surplus has slowed, no longer offsetting the widening trade gap.

On the JPMorgan forecast, India's current account deficit-to-GDP ratio is poised to hit an eight-year high of 1.4 per cent in 2005-06. The deficit is widening against the backdrop of slower growth in capital inflows, especially portfolio investments, indicating a bias towards a dollar-rupee weakness.

JPMorgan forecasts that the US Fed funds rate will rise another 150 basis points (bp) to 4.25 per cent by end 2005. India's reverse repo rate is forecast to increase only 50bp (excluding the 25bp hike this week) over this period, resulting in a less favourable rate differential, and suggesting that interest rate-sensitive capital inflows will moderate further.

On the JPMorgan calculation of the RBI's five-country REER basket, the rupee has risen a sizeable 4.5 per cent relative to its value in 1993-94, taken as an equilibrium value. It is likely that the RBI will not allow much more real rupee appreciation.

The RBI's REER index, a critical input to its currency policy, has this year stayed close to the expensive end of its observed band. Indeed, the RBI sharply stepped up its intervention in February and March when record equity inflows threatened to trigger a sharp rupee appreciation.

A reversal in portfolio inflows so far in April (-$114 million as on April 25), and deterioration in the balance of payments are likely to make the RBI averse to further rupee appreciation. Also, considering that the weak dollar trend is starting to fade, the RBI will continue to restrain the rupee strength in the near term, and may even favour a slightly weaker exchange rate later in the year.

The positive forces affecting the outlook for the rupee include a revaluation of the Chinese yuan.

JPMorgan expects an exchange rate regime change in China in the next three months, with the first likely window of opportunity in the May 1 to 7 "Golden Week" holidays. A move close to May 18 could also be likely, since this is the date when China will expand the interbank market from four currency pairs to eight and introduce market makers. (Of course, the timing depends on the Chinese leadership, which has said that it will try to surprise the market.)

The first move is expected to be a widening of the trading band by 1-1.5 per cent on either side of the midpoint. The midpoint of that band would then be allowed to track up against the dollar by 7 per cent by end-2005, and by 10 per cent over the next 12 months.

Our analysis shows a statistically significant positive correlation between expectations of a yuan revaluation and a rupee appreciation. However, this may merely reflect the fact that speculation on a yuan revaluation has usually been most aggressive in periods of general dollar weakness.

In light of the current overvaluation of the rupee on the RBI's standard measure, the RBI is likely to intervene in the forex market to maintain the dollar-rupee in a tight range. This would mean allowing depreciation against other currencies to narrow the rupee's average overvaluation.

JPMorgan expects Asian exchange rates to strengthen further against the dollar in response to the expected yuan revaluation. This broad Asian forex strength could inspire a rally in the rupee as well, supported by investors seeking to diversify forex positions across Emerging Asian currencies.

However, India and the rest of Emerging Asia have little overlap in their exports, suggesting only a small impact in India's case from regional forex appreciation. Indeed, none of the Emerging Asian economies are included in the RBI's trade-weighted five-country REER index, and they cumulatively contribute less than 10 per cent to the RBI's broader 36-country REER index. Instead, the US, the EU, the UK, and Japan have been India's most important trading partners.

With India's current account deteriorating and interest rate differentials narrowing steadily, the burden of ensuring a stable to strong rupee will increasingly fall upon equity inflows. If the pace of these inflows falters and/ or if the global weak dollar trend wanes "" both scenarios with a reasonably high probability of occuring within the next few months "" the rupee will probably under-perform substantially.

Following a near-term strengthening towards 43, JPMorgan currently forecasts dollar/ rupee to depreciate towards 44 by March 2006, but the risk to the forecast is biased decidedly to greater weakness.

(Rajeev Malik is senior economist, JPMorgan Chase Bank in Singapore, and Siddharth Mathur is currency and fixed income strategist, JPMorgan in Mumbai. The views expressed here are their own)