The curious thing about the dog in the night-time”, Sherlock Holmes explained to the bewildered Scotland Yard detective in Conan Doyle’s celebrated short story “Silver Blaze” “is that it did nothing”. A similar thing can be said about the rupee’s recent behaviour. Despite the sharp run-up in oil prices on the back of the crisis in West Asia and North Africa and predictions of a sharp fall, the rupee remained remarkably stable through most of February and early March. In fact, while it remained static up to the first fortnight of March, it defied all logic and intuition and actually gained against the dollar over the last couple of weeks even as the upward pressure on fuel prices continued unabated. This, to put it mildly, is unusual.
Basic economic theory suggests that for an economy that is a large net buyer of oil (India’s oil bill for 2010-11 is likely to be in the ball-park of $100 billion), a rise in prices should lead to a depreciation in the currency. Recent history shows that this response can actually be quite quick. As oil prices began to rise in February 2008, the rupee started to depreciate immediately. Between April and July 2008, it lost nine per cent. Why is this time different? Part of the explanation lies in the fact that there have been strong inflows in this period. In March itself, foreign institutional investor (FII) portfolio flows were a hefty $1.5 billion. Market sources claim that flows related to external commercial borrowings by companies were even larger in this period. There were some other lumpy inflows, too, related to foreign direct investments. Exports have been strong over the last few months and they, too, should have provided support. The other reason for the rupee’s current insensitivity to oil prices perhaps lies in the way oil imports are being funded. Unlike the previous episode, oil importing companies seem to have fairly solid dollar credit lines in place that they are using to fund their rising bill. Besides, a part of currency exposures in their imports is hedged.
Both these factors have meant that there hasn’t quite been a mad scramble to buy dollars in the spot market in the wake of high oil prices. This does not, however, mean that the local currency, and by extension the economy, has become entirely immune to oil price variations. If oil prices remain high, the sheer heft of a rising trade deficit could take its toll on the currency. Oil imports might find it difficult to roll over their credit lines and interest rates could be reset at much higher rates. All this could mean that the rupee will reverse course and start to depreciate. However, the extent of depreciation could be far more muted than in previous episodes of overheated oil markets. The bottom line is that while the currency might not be able to buck the “fundamentals” altogether, its current trend suggests that the oil sector in particular and the Indian economy in general are in a much better position to handle even an oil shock. This is perhaps one of the reasons why despite the obvious macroeconomic risks associated with oil, investors have loosened their purse strings and have started investing in Indian stocks.
