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The rupee has undergone a significant transformation over the course of the current financial year. It has largely mirrored the change in the external sector fundamentals of the country.
A year ago, the Indian economy looked vulnerable on the external front, with the current account deficit (CAD) peaking at 6.5 per cent of gross domestic product (GDP) in the third quarter of 2012-13. This vulnerability was tested in May 2013, when considerable global financial market volatility was triggered when the US Federal Reserve hinted it might start tapering its monetary stimulus. India had then witnessed a significant capital flight and the rupee plummeted from around 54.3 against the dollar in March 2013 to a peak of 68 in August 2013.
Since then, there has been a transformation in the country's CAD, which saw a record high of 4.8 per cent of the GDP in FY2013 and is expected to close at 1.7 per cent for FY2014. The strengthening of the CAD was driven primarily by three things: Regulatory restrictions on gold, slowing of imports due to growth slowdown and a push to exports, driven by sharp depreciation of the rupee and recovery in the global economy. Simultaneously, the Reserve Bank of India (RBI) shoring up capital flows through significant incentives for non-resident Indian deposits helped improve external sector fundamentals.
This improvement over recent quarters has also helped lower the rupee's volatility. Realised monthly volatility in the rupee has reduced by 70 per cent compared to what it was in August.
The benefit of this stronger macroeconomic position on the external front was evident when the US Federal Reserve actually started tapering its bond-buying programme in December 2013. While emerging markets (EM) experienced substantial volatility in January, the rupee remained resilient, reflecting the renewed confidence. In fact, the improved external sector dynamics helped create a positive market sentiment, leading to an increase in portfolio inflows since December.
Going ahead, it does appear on the back of current calculations that external financing concerns have diminished and India does not need to depend on portfolio flows to manage the financing of its CAD in the coming year.
However, as there is a renewed interest in capital markets in view of the coming general elections, the rupee is likely to take cues from the performance of domestic equity markets. In such a situation where there are sharp capital flows, the RBI's stance on the currency becomes important in determining the trajectory.
Sustainability of CAD compression is crucial to maintain the long-term strength of India's external sector position. The trajectory of the rupee in this financial year has demonstrated both the vulnerabilities of dependence on capital flows in managing high levels of imports and shown that a rupee-level supportive of exports can help place the country in a stronger position. We, therefore, believe RBI is unlikely to let the rupee appreciate significantly. While short-term spikes could happen in the medium term, the currency will stay at a level that keeps exports supported, allows for replenishment of foreign exchange reserves and keeps the rupee safeguarded from vulnerabilities because of global volatility.
So long as a reform-oriented government comes to power, we expect the currency to remain supported by capital flows. Continuation of the improvement seen in the CAD will also buoy the rupee. The upside risks seem limited and it is expected to trade in a range of 60-62 against the dollar in the medium term. In the short term, there could be intermittent spikes below 60 on the back of large capital flows.
The author is senior general manager and head, global markets group, ICICI Bank
