The last financial year saw the rupee on a roller-coaster. It swung from an annual high of 53.74 per dollar to a historic low of 68.36 and strengthened again till the 60 level. The current account deficit (CAD) and the trade deficit ballooned to alarming proportions before being reined in by import controls, especially tough measures targeting gold.
The current account deficit fell from $89 billion in 2012-13 to $36 billion in 2013-14. The trade deficit saw a drop from $190 billion in 2012-13 to $139 billion in 2013-14. The substantial net foreign institutional investor (FII) inflows of the past three months have been instrumental in pushing the rupee back up again. Forex reserves have risen above the $305- billion mark.
The probability of an external balance of payments crisis developing is now minimal. However, the trade data of the last two months also underlines the fragility of this seemingly strong recovery. Imports have compressed on the basis of two things. One is a drop in capital goods imports, due to the slowdown. The second is a drop in legal gold imports. Economic recovery will lead to more demand for capital goods. Legal gold imports will also rise if controls are eased.
In February 2014, the rupee strengthened. Exports shrank in dollar terms even though imports continued to shrink. In March, the rupee strengthened more as the pace of FII buying accelerated. Imports reduced a little in March, exports dropped again.
If the rupee stays at these levels or strengthens more, there is every chance the trade deficit will widen a lot in 2014-15. This will inevitably exert upwards pressure on the CAD. Various institutional estimates suggest that the market is braced for the CAD to hit $45-50 billion in 2014-15, while the trade deficit could rise to $153-155 billion.
Currency management will be a tricky task in 2014-15, whatever happens. If FII and FDI inflows remain strong, there will be upwards pressure on the rupee. If there are forex outflows, there will be downwards pressure on the rupee.
The RBI has to ensure that the rupee stays within a certain band for the positive effects of depreciation to be available. The rupee therefore, cannot be allowed to strengthen too much, or even allowed to remain at the current levels for a great length of time.
This means the RBI will have to buy dollars, fattening up reserves if there are net inflows tending to push the rupee up further. This is tricky. Every dollar buy releases an equivalent amount of rupees and the central bank will have to prevent inflationary effects from the increased money supply. That will probably involve enhanced sales of treasury instruments to pull rupees out of circulation again.
On the other hand, if there are net outflows pushing the rupee down, the RBI will have to intervene by selling dollar. It will then have to find a way of putting the rupees it receives from dollar sales back into circulation, in order to avoid deflationary effects.
The theory underlying such manipulations is not trivial. If a central bank targets a certain fixed exchange rate, and it allows its currency to be freely traded, it cannot control monetary policy. This is sometimes called the Impossible Trinity. Here, the RBI will target a band (rather than a fixed rate) and it allows the rupee to trade only with certain restrictions. So it does have room to juggle money supply. It will need that flexibility to manage inflation. But staying on top of such operations requires delicate timing, pragmatism and disciplined adherence to the targeted currency bands.
The RBI may struggle to cope with this in the immediate future, given the political situation and the power of political narratives. Election outcomes could have a huge impact on FII attitudes. In that case, the rupee could strengthen much more, or slide dramatically.
But if the RBI succeeds in currency management, the rupee will bounce around, either between 60-63, or maybe between 59-64. The width of the band depends on the central bank's perceptions. However, the trade data suggests that the rupee is close to the higher end of its tolerance and it should weaken soon, one way or another. Long-term trading strategies built upon that assumption of a weaker rupee by New Year could be fruitful.
The current account deficit fell from $89 billion in 2012-13 to $36 billion in 2013-14. The trade deficit saw a drop from $190 billion in 2012-13 to $139 billion in 2013-14. The substantial net foreign institutional investor (FII) inflows of the past three months have been instrumental in pushing the rupee back up again. Forex reserves have risen above the $305- billion mark.
The probability of an external balance of payments crisis developing is now minimal. However, the trade data of the last two months also underlines the fragility of this seemingly strong recovery. Imports have compressed on the basis of two things. One is a drop in capital goods imports, due to the slowdown. The second is a drop in legal gold imports. Economic recovery will lead to more demand for capital goods. Legal gold imports will also rise if controls are eased.
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Export growth is clearly linked to depreciation. The depreciation started in June-July 2013. The corrective impact was immediately apparent. In dollar terms, exports grew substantially every month in between July 2013 and January 2014, compared to July 2012-January 2013. In that same period of July 2013-January 2014, imports in dollar terms shrank every month.
In February 2014, the rupee strengthened. Exports shrank in dollar terms even though imports continued to shrink. In March, the rupee strengthened more as the pace of FII buying accelerated. Imports reduced a little in March, exports dropped again.
If the rupee stays at these levels or strengthens more, there is every chance the trade deficit will widen a lot in 2014-15. This will inevitably exert upwards pressure on the CAD. Various institutional estimates suggest that the market is braced for the CAD to hit $45-50 billion in 2014-15, while the trade deficit could rise to $153-155 billion.
Currency management will be a tricky task in 2014-15, whatever happens. If FII and FDI inflows remain strong, there will be upwards pressure on the rupee. If there are forex outflows, there will be downwards pressure on the rupee.
The RBI has to ensure that the rupee stays within a certain band for the positive effects of depreciation to be available. The rupee therefore, cannot be allowed to strengthen too much, or even allowed to remain at the current levels for a great length of time.
This means the RBI will have to buy dollars, fattening up reserves if there are net inflows tending to push the rupee up further. This is tricky. Every dollar buy releases an equivalent amount of rupees and the central bank will have to prevent inflationary effects from the increased money supply. That will probably involve enhanced sales of treasury instruments to pull rupees out of circulation again.
On the other hand, if there are net outflows pushing the rupee down, the RBI will have to intervene by selling dollar. It will then have to find a way of putting the rupees it receives from dollar sales back into circulation, in order to avoid deflationary effects.
The theory underlying such manipulations is not trivial. If a central bank targets a certain fixed exchange rate, and it allows its currency to be freely traded, it cannot control monetary policy. This is sometimes called the Impossible Trinity. Here, the RBI will target a band (rather than a fixed rate) and it allows the rupee to trade only with certain restrictions. So it does have room to juggle money supply. It will need that flexibility to manage inflation. But staying on top of such operations requires delicate timing, pragmatism and disciplined adherence to the targeted currency bands.
The RBI may struggle to cope with this in the immediate future, given the political situation and the power of political narratives. Election outcomes could have a huge impact on FII attitudes. In that case, the rupee could strengthen much more, or slide dramatically.
But if the RBI succeeds in currency management, the rupee will bounce around, either between 60-63, or maybe between 59-64. The width of the band depends on the central bank's perceptions. However, the trade data suggests that the rupee is close to the higher end of its tolerance and it should weaken soon, one way or another. Long-term trading strategies built upon that assumption of a weaker rupee by New Year could be fruitful.