For many decades, the value of the rupee was officially and unofficially fixed. An Indian could buy and spend the princely sum of $50/ annum at the official rate if he was travelling abroad. Or he could buy any amount of dollars at a blackmarket rate of about 2.5x the official rate.
This is a far cry from now, when the rupee's gyrations and the Current Account Deficit (CAD) are key variables for tracking India's macro-economic health. The rupee has just hit a record low against the US dollar and it is down against most major world currencies.
The implications are bad. The rupee has fallen because foreign institutional investors (FIIs) exited both Indian debt and equity in June. As the rupee falls, imports become more expensive. Energy-related fuels - crude, gas and coal- soar in terms of rupee values.
Inflation will climb and, therefore, there will be less room for interest rate cuts. So, growth will be hit. That could trigger more FII selloffs, pushing the rupee down more. Given sufficient pressure on reserves, there could just be a balance of payments crisis. On the positive side, exports become more competitive.
The fear of a forex crisis may also force more reforms. If the FIIs change attitude and start buying again, that will give the government some time to find ways to promote exports and to encourage Foreign Direct Investment (FDI). Here are some approximate numbers. The RBI has about $290 billion in reserves. About $30 billion is in bullion and, therefore, emergency use only. So, there are about $260 billion of "normal" reserves. This is about six to seven months of import cover.
India also has $390 billion in external debt. About 44 per cent, or some $171 billion, is due for repayment in the next 12 months. If that short-term debt is not rolled over, or financed, it could cause a big drawdown on reserves.
A trade surplus is impossible in 2013-14. The Trade Gap (excess of goods imports over exports) was nearly $190 billion last year. Rising exports may at best, reduce the gap. Services exports, meaning IT, and remittances and tourism are all positives.
But the sum of these (services+ exports versus services+imports) is negative, leading to a record Current Account Deficit of $89 billion in 2012-13. That is 4.8 per cent of GDP. In Q4 2012-13, the CAD reduced to "only" 3.6 per cent of GDP or $18.1 billion. But a CAD of over 2.5 per cent is generally reckoned unsustainable in the long run. The CAD will reduce in 2013-14, but there is no chance of a Current Account Surplus.
How does India finance its CAD and service its external debt in the next 12 months? It would have to rely on a combination of FII and FDI inflows. In 2012-13, FDI flows dropped to a 10-year low of $31 billion. FII investments amounted to about $25 billion. If FDI recovers and FII revert to large-scale buying, maybe $ 60 billion could come in, or even $65 billion if we may be optimistic. Even so, there will be a reserve drawdown. Financial institutions project that reserves could fall by $30-35 billion in 2013-14.
Of course, if FIIs continue to sell, they could put intolerable pressure on the rupee. FIIs hold rupee assets amounting to about $140 billion, after selling about $5 billion in June. If they sell more, there will be a stress point where markets and policy-makers panic. If that happens, all predictions are off.
Reviewing the numbers, there is a strong case for expecting the rupee to fall quite a bit further.
Is there a target ? Unfortunately, this is the kind of situation where setting targets is impossible. Currency trading is also high-risk because of the extreme leverage.
One hopes that the fall will be in orderly fashion. If it is, being long on the US dollar could be highly profitable over the next year or so, notwithstanding likely bounces from the rupee. A good trend-following strategy would pick up profits on both sides, reversing positions every time the rupee pushed back.
The incalculable danger in forex trading is the possibility of the government hitting the panic button. If it does, it could do many things. The most drastic would be to reimpose currency controls. Another possibility would be to hike interest rates up suddenly.
Investor should also be looking to go long on exporters in general. This is less risky since exports should grow in almost every scenario. Share prices of smaller exporters have been beaten down to reasonable valuations. Exports will certainly increase in 2013-14 and the falling rupee could mean windfall gains for some exporters.
