3 years of Narendra Modi govt: Rupee rise defies conventional wisdom but don't rule out a reversal
The currency management is mostly the RBI's job but the government policies that attract dollar inflows do have an impact on exchange rates
The three years of the Modi Government has been extremely interesting as it has been embellished with a lot of positive energy in the direction of economic policy with several bold measures being taken like demonetization, Aadhaar linked policies and DBT. One area which merits attention is the currency because of late the pace of appreciation in the rupee has gone contrary to conventional wisdom which had prophesied a major depreciation less than six months back. The rupee today stands strong waiting to break the Rs 64 barrier even while other global currencies have been affected by a stronger dollar.
When the government took over, the rupee was in the region of Rs 60/$ after a major run in 2013 which was caused by sharp increase in imports (oil and gold) and depletion of forex reserves. The RBI had put together a plan to get in dollars through a swap facility on FCNR (B) deposits at 3.5 percent which got in above $30 bn in 2013. Since then the only factor that was working against the rupee was external to the system in the form of the Federal Reserve and its move to roll back the quantitative easing programme and increase rates. This did affect the fundamentals.
The currency and its management is more of an issue with the Reserve Bank of India (RBI) than the government and hence while the latter’s role was more in the form of laying down policies that influenced investment through the FDI and routes, the former played a major role in rupee stabilization. The dollar rate depends on the inflows and outflows of dollars into the system. The inflows come from exports, software receipts, remittances, FPI, FDI, NRI deposits and ECBs in a broader sense. Outflows are primarily through imports and at times FPI. As we have traditionally had a current account deficit, the capital account is in surplus to balance the external account.
The rupee had fallen in the last three years from an average of Rs 59.31 in May 2014 to Rs 65.92 in March 2017. Since then it has been strengthening further to almost cross the 64 mark. The balance of payments has been fairly strong through these years. The curbs put on gold imports and the fall of crude oil price has combined to steady the current account.
The government’s pro-FDI stance had brought in high investment flows which peaked at around $55 billion in FY16 and would have been matched in FY17 (up to December it was $48 billion). FPI too has been in the positive territory in FY17 though it did receive a setback in FY16 which was also the time when the rupee fell to around Rs 67/$ by March. In fact there was a brief phase around September-November, when the rupee did appear to move towards the 68 and 69 mark which coincided with the period when the FCNR (B) deposits had to be redeemed. Here, to the credit of the RBI, the rupee was managed well as the RBI supplied dollars more through the forward markets to ensure that there was limited volatility in the market.
A factor which had driven currencies in the last two years has been the expected stance of the Fed and once it started increasing rates, which was then taken to be a given in future – there are till two more hikes expected this year, funds flows moved away from the emerging markets to the USA. This was when the debt component of FPI was affected. Interestingly, almost all emerging market currencies have been falling against the dollars and the rupee has been a better performing one which has seen limited RBI intervention to maintain export competitive advantage. The election of Donald Trump further added pessimism in the market as his policies do point towards restrictions on free trade and immigration to protect American jobs which will impact the IT industry and hence software receipts flows in future.
However, of late, since April the flows of dollars have increased on almost all fronts. First, the trade growth numbers have turned positive which has started the inflow trigger. Second, the RBI has raised the debt limits which can be used by the FPIs in GSecs, which is now linked to outstanding debt of the central and state governments. Third, the FPI flows into equity have also started increasing which accelerated after the state government elections w here the NDA received an overwhelming majority. This has been taken to be indicative of the fact that reforms will be swifter in future. Fourth, sentiment has turned positive further as it is believed that the RBI will not be coming into the market to stabilize the rupee as it will lead to excess liquidity in the system at a time when the central bank is grappling with the same on account of the demonetization. Fifth, the confidence in the government continues to play positive for FDI and it can be assumed that this pace will be maintained once the GST comes in which is the next big reform to be implemented in July.
Looking at the fundamentals, it does look like that the situation should be reversed as time goes by. The trade deficit has already widened in April, which though a single data point could increase going ahead. OPEC is already thinking of taking more action to prop up prices. The US policies could affect the software flows into the country (IT companies are already cutting back on staff). Higher Fed rates would tend to divert FPI funds. The ECB route is no longer attractive with the interest rate differential coming down - US rates are going up and Indian rates (MCLR) down. While conventional wisdom would still argue in favour of rupee depreciation during the year, the present trends towards accelerated appreciation belies this belief.
Hence, for the very short run which can be a month, the rupee will be in the upward trajectory and the depreciation story could run only after some of these fundamentals become sharper than they are today.
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