Where is the rupee heading?

Rupee will depreciate vs $

M R Madhavan
Bank of America, Singapore

Two factors drive the rupee: flows and central bank stance. Flows have been rupee-positive in a major way for the last two years, and indeed, the recent rally of last week was driven by the surge from investments in IPOs. The central bank has been intervening through the rupee's appreciating move, and dampening any large moves.

Flows: Let us take a look at the composition of the flows. Data available for the first half of the fiscal years shows that much of the inflow is speculative in nature.

These include portfolio flows (both equity and debt), banking capital (arbitrage between international and domestic rates), and corporate positions through the timing of hedging trade flows exports are over-hedged and imports under-hedged).

There is no significant acceleration in long-term money such as FDI. And, this year, the trade deficit has widened, and will shrink the current account balance.

The composition of flows indicates that the system is heavily positioned short $-Re. And many of these flows including export hedging, debt portfolio and banking capital are close to their regulatory caps.

Any factor that changes the view on the pair could turn the flow in the other direction. That is the major risk. Of course, this would not turn into a large fall in the rupee as RBI has more than enough reserve to dampen any move.

RBI preferences: Though the RBI officially maintains that it does not have a target for the rupee, its past behaviour suggests that the real effective exchange rate (REER), in particular the five-country 1993-94 base index, has been a key medium term goal.

How else do you explain the fact that this has stayed within a +/-5 per cent range around its "fair value" for eleven years? How will this variable behave ahead?

The fact that India's inflation (say 5-5.5 per cent for the rest of 2004) is significantly higher than the REER basket, indicates that the rupee has to depreciate 3.5-4 per cent against the basket in order to maintain its REER.

Given our view that the dollar will recover towards the end of the year against the other majors implies that the rupee needs to depreciate against the dollar to maintain REER. It will need to move above near 46.50 to stay within the REER band.

Is imported inflation, given the uptrend in global commodity prices, an issue which will drive RBI to let the currency appreciate? One cannot rule this out.

The RBI is balancing two variables: export competitiveness and imported inflation. Recent data suggests that export growth has been positively correlated to REER.

Until RBI is certain of improved demand in the domestic economy (that is, wait till at least 2004 monsoon), it might prefer to keep the export growth momentum positive; keeping the rupee a bit undervalued would also help domestic manufacturers adjust to the reduction in tariffs.

The rupee could appreciate a bit in the very near term, driven by FII flows. However, by the end of the year, a stronger dollar as well as increases in Fed funds rate will reduce the motivation for these flows.

The inflation differential will also push the rupee to the overvalued end of the REER band. These factors will drive a rupee depreciation towards 46.50 to a dollar.

A strong Re is here to stay

Debasish Datta
Senior banker turned consultant

As one writes this, the Indian rupee has been hurtling up against all the white (read non Asian) currencies - more than 1 per cent against the US dollar and the euro in just the four days from Monday to Thursday last. Against the dollar, it appreciated by nearly 9 per cent in about 21 months from 49 in early June 2002 to 44.72 midweek last.

Let us for a moment try to see the big picture that has led to the realities of the day.

The historical cycle running through centuries - first the political / economic colonisation of Asia by the West followed by reluctant decolonisation accompanied by vertical and horizontal emancipation and value addition to human education, quality of life, and technical skills over large populations in Asia has now started yielding results in the form of sustainable economic strength.

During the past couple of years, all Asian currencies excepting the Philippine peso have appreciated resolutely against the dollar.

Overwhelming political, economic and technological dependence of the East on the West is being replaced steadily by dependence of the West on the East for increasing numbers of performing personnel and growing consumer markets progressively insulating themselves against historical strong arm tactics of the Western vendor.

Hence, it is natural that the currencies of these Asian states would appreciate, to which the Indian rupee is no exception.

This appreciation, especially for the rupee, would abide, since it is backed by a large country with immense natural and human resources, unlike many other Asian states.

Given this central idea that the appreciation of the rupee (except for temporary falls against non-dollar European currencies resulting from their gyrations against the dollar) will not abate, exporters would be well advised to quote in rupees, or to hedge receivables as soon as commercial / financial contracts are concluded.

Importers and borrowers, whether in rupees or other foreign currencies could, as policy, have at least half their payables converted to dollars, covering of course future interest rate risks appropriately.

While 44.90 - 45.10 could contain any immediate correction to the dollar/rupee rate, it is hard to see the rate climbing beyond 45.25/35, calls for compulsory hedging by overseas lenders and Indian outward investments notwithstanding.

These would be largely matched by jumping FDIs and outsourcing from abroad. Lower down it is a bottomless pit, with strong supports at 44.40 - 60 (which is already breached), then through towards 43.80 and progressively lower over the ensuing year.

It is not the dollar's weakness alone, it is the rupee's strength. Not to worry, what the exporter loses through currency appreciation would be matched by increasing sales and reduced costs - characteristics of a growth driven state.

Besides, other Asian competitors would also have appreciating currencies, negating to a certain extent any adverse competitive effects on exports.

China, though an exception, holding their currency rate static artificially, is expected to relent sooner than later and allow gradual currency appreciation. The strong rupee, in any case, has come to stay.