The rupee has been behaving in a whimsical manner in the past and there are different signals available on the factors that influence its movements. Just when it looked to strengthen towards Rs 66/$, it has gravitated half way to the Rs 67 mark and one is uncertain of future movements.
On the face of it, the rupee is probably one of the better performing currencies as can be seen relative to the depreciation witnessed by other emerging markets. Yet we are uncertain of whether we want to have a stable rupee or a currency which slides downwards with the rest at a better pace. Also volatility in the currency at times becomes difficult to explain and will be of concern to the central bank. And above all, the market is always guessing which way the RBI will react to such swings in the rupee. What can one make of it?
A fair value for the rupee would be around Rs 66/$ based purely on the fundamentals. And the fundamentals are defined in net terms by the changes in the forex reserves. These reserves have been stable at around $350 billion for some time which can be summarised by saying that after looking at all inflows and outflows of dollars into the system, the reservoir of reserves has remained firm. Compared with March end, we have added around $10 billion and around $30 billion over last year which is quite commendable.
The rupee has declined by 4.2% over December 2014 and stands out in the list of competing currencies. China matched this fall by 4.3%. Australia (11.4%), Indonesia (10.4%), Thailand (9.4%) were the ones around the double digit mark, while Malaysia (22.6%), Brazil (43.8%), Argentina (50.8%) and South Africa (31.9%) were the big losers in the market.
Our markets have been nervous about the exchange rate and there have been interventions by the RBI in both the spot and derivative markets to stabilize the rupee, ostensibly because the volatility was not acceptable. The latter was significant because normally the central bank intervention is in the spot market. The larger question is whether or not the central bank should intervene when the volatility is caused by global disturbances and not distortions in fundamentals.
The fundamentals of the balance of payments look strong. The trade deficit has narrowed down in net terms with global commodity prices headed southwards and not showing any signs of a pick-up. Software receipts and remittances have been increasing mainly due to gradual growth impulses from the western world. These two sources of forex are always steady and provide support to the current account balance. This balance appears within the 1.5% mark which is quite comfortable. Therefore, unlike 2013 when the CAD went awry due to a high trade deficit, the situation has been fairly strong this year.
The capital account too has been positive. While FPI withdrawal from the equity markets is a global phenomenon and will continue to be so with the Fed likely to raise interest rates in the course of 2016, the debt flows have been more encouraging. Further by linking the FPI quotas to government debt on an ad valorem basis, the scope for investments also increases as government debt moves up.
FDI has been very positive and higher than that last year in the first half of the year and almost $9 billion higher for the 9 months of 2015. Quite clearly investors do see a credible growth path for India in the years to come which has been backed by some strong action by the government on the doing business environment. The ECB market which has not been a major contributor to the balance of payments could show some slowdown due to higher cost of borrowing as well as cost of hedging which is today close to 6-6.5% on an annualized basis. NRI deposits have remained fairly stable and rarely make a turnaround unless there are fundamental problems at home, which is not the issue with India being the fastest growing economy in the global space.
Therefore, the fundamentals do justify a stable rupee in the region of Rs 66/$. However, the global environment has become volatile for two reasons. First US recovery and increase in interest rates indicate that USA is becoming stronger which in turn will strengthen the dollar. This is one reason why all currencies are weakening against the dollar.
Second, China has started evaluating the Yuan which began in August 2015. The rate of depreciation is equivalent to what it is today in India and there are expectations that this will be continuous as it strives to boost its exports. This can be unsettling for the global economy. The response of the US would also be interesting as it loses its relative competitive advantage with a strong currency in a trade pie which is not quite growing.
The question then is how much should the rupee be allowed to slip? If fundamentals do not justify a sharp fall, should we be taking advantage of this volatility in the market to support exports? Our exports have been declining continuously which is also a global phenomenon as prices of commodities have declined. But when the currency falls, then a country can gain a competitive edge by letting go of its currency. While it may not be decisive, at the margin India could get out competed by countries like China, Bangladesh and Pakistan which also deal with export of traditional goods.
This could be a dilemma for the central bank which has to take a call on the currency. Ideally letting the market decide as long as it is in line with fundamentals is a plausible strategy. But today it may be appropriate to also judge how the rupee is faring vis-à-vis other competing currencies and hence intervention should be only when it gets counter-productive.
All this means that the rupee will continue to be volatile with Rs 66 acting as a floor probably. The RBI will play a critical role in terms of limited intervention in the light of the exports effect. Higher imported inflation will be the concern on the other side. Hence while we may be more certain of the direction of interest rates, the same may be hard to conjecture for the rupee.
The writer is chief economist at CARE Ratings, and his views are personal