The rupee has been under pressure since early August as risk aversion fuelled by the European sovereign crisis and downgrade of US sovereign debt by Standard and Poor’s drove away equity investments from Indian markets. In August alone, foreign institutional investors dumped $2.3 billion worth of Indian stocks and sought safer havens like US treasury bonds. Despite this rise in risk aversion, the correction in oil prices (and indeed other commodities) was shallow and helped lower India’s current account deficit only to a limited extent. The payment of dues to Iran (of roughly $5 billion) in this period abetted depreciation. All this should please the often vociferous group of economists who believe that an undervalued, or at least a fairly valued, rupee is critical for growth. The real effective exchange rate (REER) terms (measured against a basket of 36 currencies) showed a value of about 103 in June (the latest data available). This means that adjusted for inflation, the rupee has appreciated a meagre three per cent over its base level of 2004-05. This is partly owing to the fact that over the last couple of years, the Indian currency has underperformed most of its Asian peers. In August the index level should have slipped further on the back of the nominal depreciation.
But there might not be room for complacency. Based on the six-country REER measured against our key trading partners – the US, UK, Japan, China, Eurozone and Hong Kong – the currency looks considerably overvalued. In July, it printed at over 118 (taking 2004-05 as the base), reflecting the large inflation differentials between India and the major buyers of its exports. This lack of competitiveness vis-à-vis trading partners might hurt India’s exports as the imperatives of fighting recession get local firms to manufacture products that they usually import. Besides, currency movements are notoriously fickle and the fact that the rupee is depreciating now does not necessarily mean this trend will sustain. There has been a strong flow of external commercial borrowings (a hefty $12 billion in the April-July period itself) on the back of a large difference in local interest rates and those in developed markets. This is likely to continue. Once the equity markets shed their aversion to risk and wake up to the fact that India, despite a slowdown, will grow much faster than both the US and Europe, flows could return to India. The US Federal Reserve seems committed to liquidity easing, and policies like operation twist (where the central bank sells short-term bonds and buys long-term bonds) and ultimately another round of quantitative easing are very much on its menu. These would turn on the spigot of cheap dollars that could chase Indian assets. If there is a gush of dollars in the future, the current account deficit (most forecasters peg it between 2.7 and three per cent of GDP) is unlikely to absorb it entirely. The result could be another round of sharp rupee appreciation. Over the past couple of years, the Reserve Bank of India (RBI) has refused to intervene in the foreign exchange market. It may have continued with this stance in the face of a rising currency to help manage inflation at home and minimise the impact of rising commodity prices. But this could also compromise export growth and exacerbate the slowdown. Perhaps a rethink of RBI’s currency policy and some explanation of it would help.
