The future of the rupee

Post a short-term correction, the rupee could see long-term gains if dollar index falls

How should one think of the future of the rupee in the medium to long term? The simple answer is that it depends on the fate of the dollar. While this might sound like an empty tautology, we think it is not as trivial as it appears. The conventional tack to gauge the dollar’s behaviour is to look at the trade weighted dollar index, an average of dollar exchange rates against eight major developed market (DM) currencies. The rupee is not part of this basket but its movements are influenced quite significantly by what happens to this index.
 
The current strength of the rupee, for instance, was underpinned by a sharp drop in the dollar index, the unwinding of the so-called “Trump trade”. From a high of 103.8 on, the index is down to 98.7. This unwinding largely priced in disappointment over the fact that “Trumpnomics” is yet to get off to a credible start even after 100 days of the new administration being in office. Despite the president’s grandiose promises in his campaign, his economic policy announcements were the proverbial damp squib. To begin with, his administration failed in its first attempt to pass legislation to repeal the existing health insurance programme  (Obamacare). Second, the tax reform plan announced a couple of weeks ago seemed like a shoddy “cut-and-paste” version of a campaign pamphlet. Besides, his promise to “withdraw” from trade agreements like the North American Free Trade Agreement (Nafta) now appear to have reduced to rounds of tame renegotiation of some clause. And so forth.

 
To be fair, some of the loss in the dollar index was driven by good news from Europe, particularly the first round win of pro-European Union candidate Emmanuel Macron in the French presidential elections and the majority of polls that predict an ultimate victory for him. If these are to be believed “Frexit” is unlikely to happen and the union is likely to stay together.
 

However, the medium and long-term future of the dollar is not just about the US President’s initial waffling or U-turn on election promises. While Trump’s grandiose plans of a reduction of the corporate tax rate to 15 per cent and spending on infrastructure will pass through a reality scanner and appear in considerably more timid version, most analysts agree that neither him nor his advisors have paid much attention to what it will do to the deficit. Trump’s entire fiscal approach seems to be premised on the fact that lower tax rates and reduced regulation will ramp up the economic growth rate sharply (a few analysts have pointed out that some of the Trump calculations bet on a 4.5 per deficit), a projection that has no takers among economic pundits.

 
What could all this mean for the rupee? The Trump administration’s tax-and-spend plan is most likely to push the American budget deficit up. While growth could fall well short of expectations despite the fiscal push, interest rates will surely move up as the government borrows more to pay for its deficit. The question: Would higher interest rates push the dollar up or would it in fact cause depreciation? Predictably, there is divergence of opinion among economists on this issue. The Reagan era of the early 1980s saw a rise in the dollar despite a rising deficit.
 
That said, the dominant view today seems to be that given the massive level of government debt, additional fiscal expansion could actually drive the dollar down. More recent empirical evidence seems to bear this hypothesis out. The dollar index gained during the Clinton regime that was marked by fiscal consolidation (yes, there were budget surpluses as well) and plummeted as deficits grew sharply during the Bush presidency. Thus, if the Trump plan does not produce roaring growth rates and instead pushes the deficit and debt up, the dollar index could see a secular decline. That could well mean sustained pressure on the rupee to appreciate over the long term even if there is a mild correction in between.

  Abheek Barua is chief economist, HDFC Bank. Bidisha Ganguly is chief economist, CII