A V Rajwade: Rupee's exchange rate and capital flows

WORLD MONEY/ Enthusiasm for capital inflows may taper with the dip in the rupee

Four weeks ago, I had discussed in this column several myths about the exchange rate, and intervention and sterilisation policies.

The exchange rate movements of the dollar against the rupee and the euro since April 2 this year. By my estimates, the real effective exchange rate (REER) should be evidencing an overvaluation of 3 per cent presently.

One question on capital inflows is the impact of rupee appreciation on portfolio flows. As far as the debt market is concerned, in principle, the interest differential in favour of the rupee and its appreciation would surely attract external funds. But investments by foreign institutional investors (FIIs) in the debt market have been capped at $ 1.5 billion.

In the equity market, one needs to distinguish between those looking at relative returns (that is, relative to the benchmark index that the fund manager is hoping to improve upon), and those targeting absolute returns. The attitudes of the two are likely to be significantly different.

Those focusing on relative return may well consider an undue appreciation of the currency to be a negative factor for Indian equity investments, as it could squeeze the margins of many industries.

Again, the increase in the dollar values of equities, through appreciation of the rupee, is by itself immaterial to those aiming at relative returns. This is because the benchmark index itself will rise in dollar terms when the rupee appreciates, thus leaving the relative performance unaffected by the exchange rate movement.

On the other hand, those looking at absolute returns (hedge funds would be a good example of such investors) would clearly be attracted by an appreciating rupee.

But one imagines that in percentage terms, the amount invested by such investors is not likely to be significant as compared to the monies brought in by more traditional emerging market investors seeking relative returns.

It is only recently that some international funds, as distinct from India-specific or emerging-market investors, have started being attracted to Indian equities.

Incidentally, to my mind, one gap in the present balance of payment (BoP) scenario is the mark-to-market value of FII investments: what we do get are inflows and outflows and, hence, the net amount that has come in, and not the current market value of the investments. It should not be difficult to get this value from the custodians and, perhaps, the authorities need to look at and publish this information as part of the BoP data.

On the general topic of capital inflows, perhaps the largest proportion of capital is being brought in by Indian corporates, in the form of medium-term external commercial borrowings (ECBs) and, much more so, short-term capital through leading receipts and lagging payments.

With the recent dip of the rupee, the enthusiasm for such flows may taper; political uncertainties may also dampen FII flows. If they continue, there is also the question of what the Reserve Bank of India (RBI) will do once the present tranche of Rs 60,000 crore of market stabilisation bonds is exhausted. An increase in cash reserve ratio?

One other measure is to encourage Indian companies seeking ECBs to float dollar-denominated, rupee settlement bonds in the local market. The issuer will have the benefit of a dollar debt for all practical purposes, without this resulting into capital flows. Rupee liquidity will also be mopped up.

As far as the investor in such bonds is concerned, the fixed rate coupon would not differ much from that currently available to high-class borrowers in the rupee bond market. (The five-year dollar interest rate swap quotation is currently around 4 per cent. Borrowers desiring to benefit from floating rates could always do a dollar interest rate swap "" receive fixed, pay floating.) Will such bonds interest the Indian investor? That remains to be seen.

An additional measure is to encourage foreign entities to borrow in the rupee market and transfer the capital raised outside. It seems that there would be scope for this in the current circumstances "" the only actual issue has been that of the Asian Development Bank.

In the final analysis, of course, rather than abandoning the exchange rate, the authorities could consider a Chilean-type "tax" on short-term capital flows. This would require, for example, FIIs to deposit with the central bank, on an interest-free basis, a given percentage of the capital they bring in. This would make the cost of capital high and correspondingly discourage inflows.

But coming back to the exchange rate, the Infosys CFO has acknowledged that in Q4 of fiscal 2003-04, the company lost Rs 41 crore through appreciation of the rupee, and almost three times that for the year as a whole.

Clearly, the exchange rate has started to hurt. Lest we forget, there is no case in the past 60 years of fast economic growth except with an undervalued exchange rate "" Japan and Germany in the 1950s and 1960s, China over the last two decades and so on.

On the other hand, there are enough examples of crises arising from overvalued exchange rates "" Mexico in 1994-95, southeast Asia a couple of years later, Russia in 1998, Argentina in 2001 and so on. And, not to forget, the deflationary impact of uniting east Germany at a hugely-overvalued exchange rate that has dogged the German economy for more than a decade.

E-mail: avrco@vsnl.com