Where is the rupee headed?

ISSUE

Re to hit 47.50 by March

S P Prabhu
Head, fixed income,
IDBI Capital Markets

Over the last few years, India's balance of payments has been witnessing increasingly larger surpluses. The size of the surplus mounted from a modest $5.8 billion in 2000-01 to $31.4 billion in 2003-04.

While India continues to run large trade deficits, the forex inflows from 'invisibles' like services exports and NRI remittances witnessed an exponential growth.

In 2003-04, India was a net exporter of services to the tune of $10.6 billion, largely driven by IT exports. The remittances into India were of the order of $19.4 billion. These inflows resulted in India having a current account surplus of $8.7 billion, a far cry from the days of massive current account deficits.

The capital flows were also healthy, driven by FII investments and arbitrage flows arising from differentials between domestic and global interest rates.

During the last couple of years, the dollar has weakened globally, triggered by sharp interest rate cuts by the US Fed and a massive US trade deficit of $500 billion.

The Fed has cut its benchmark Fed Funds Rate from 6.5 per cent in 2001 to 1.0 per cent in 2003 to stimulate a recessionary US economy. During that period, the dollar depreciated by over 50 per cent against the Euro and 30 per cent against the Pound.

The over-supply of dollars in the market emanating from our BoP surplus, coupled with a globally weakening of the dollar, resulted in the rupee appreciating by 12 per cent. From a low of Rs 49.09 against the dollar in May 2002, the rupee appreciated to Rs 43.25 in March 2004.

The appreciation of the rupee would have been far steeper had it not been for the RBI intervention involving dollar purchases of over $50 billion. The relentless rise in RBI's forex reserves is a consequence of such interventions.

In the current fiscal year, the environment for the rupee has undergone a sea change. Firstly, the benign global interest rate scenario seems to be history.

Several central banks across the world have hiked interest rates by 0.50-1.25 per cent in response to improved economic conditions and apprehensions over possible asset price bubbles.

The hike in US interest rates by 0.75 per cent and the Fed's announcement of "measured" rate hikes over the next 12-18 months will imply strengthening of the dollar.

Secondly, crude prices have risen by almost 50 per cent during April-September. This will increase the import bill of India sharply by $8 billion and widen the trade deficit.

Thirdly, while FII inflows continue to be positive, the flows are appreciably slower compared to 2003-04. Lastly, the liquidity surplus in the money markets has been declining, thanks to aggressive sterilization by the RBI.

During 2004-05, the rupee has depreciated against the dollar from Rs 43.60 to Rs 45.91. An interesting fact is that, for the first time since the 9/11 attacks, the RBI has been selling dollars in the forex market to stem the weakening of the rupee.

I expect the rupee to continue to depreciate, albeit slowly. RBI may be expected to continue supplying dollars to "maintain orderly conditions" in the forex market. I expect the rupee to be trading around Rs 47.50 to the dollar by March 2005.

(The views expressed by the author are his personal views and not reflective of his organisation)

To stay at sub-46.50 levels

Sudrendra Rosha
Head, forex sales,
HSBC

After almost six months of being under pressure and having tested the 46.50 levels a few times, the rupee has seen some respite over the last two weeks. The unit has held below 46.00 for the last few trading days.

Does this recent move signify an end to the 6-month trend of the rupee's weakness? Will the rupee now revert to a strengthening mode as witnessed between May 2002 and March 2004?

To answer these questions one must look at the factors that changed the rupee's trend earlier this year. The market significantly oversold dollars at the end of the last financial year.

In April, the US reported a sharp jump in job creation and inflation - this in turn pushed expectations of a rate hike in the US and hence a reduction in the rate differentials between the dollar and the rupee.

Each of these factors needs to be looked at closely. Over the last six months, exporters have reduced their hedge ratios substantially by either delivering their receivables against forward contracts or cancelling the contracts themselves.

While we have not seen fresh exporter selling, the pressure created on the rupee as a result of the cancellations has reduced. Based on anecdotal data, I estimate that fresh exporter selling is unlikely to emerge until January of 2005.

While the US Fed has raised rates by 75 basis points this year, the inflation and growth outlooks for the US remain relatively benign and rate hike expectations have moderated since the second quarter.

At the same time, there has been a rise in domestic yields reflecting an expectation of a rate increase in India. More importantly, the dollar remains vulnerable as the trade and current account deficits remain high.

FII flows which were negative in May and June have turned strongly positive in August and September. While the poor monsoon and the concomitant effect on rural demand is expected to pull down the real GDP growth this year, I would suspect the strong positive India story currently prevailing in the international markets is likely to outweigh this drop.

The biggest risk to the rupee positive story remains the high international price of oil. Oil prices will impact both current flows and future expectations. A one dollar increase in crude prices impacts the nation's monthly import bill by approximately $500 million.

With a monthly trade deficit of $2 billion, any increase in oil prices would impact the rupee significantly. Given all of the above, the rupee's performance in the medium term is likely to be closely linked to two key variables - the dollar's performance against international currencies and the price of oil.

If the dollar remains on a weakening trend the rupee will benefit. In terms of a reversal of this trend, a weekly close below 1.1800 on the euro/dollar and above 113.00 on the dollar/yen would be the key variables to watch. A move in oil above $50 per barrel will put the rupee under pressure and it is likely to significantly test the recent resistance at 46.50.

On balance, unless there is a blow-out in oil, I would expect the rupee to stay below 46.50 and continue to strengthen in the medium term. We should see a move towards 45.00 through the rest of this fiscal, in line with a weaker dollar overseas. In terms of a strategy any bout of rupee weakness will provide an opportunity to sell dollars forward.