Despite hitting near 3-yr high, rupee to remain weak

By Indira Vergis

On 27 July, the rupee surged to 43.85 against the US dollar, a near 3-year high. Will the currency continue to gain muscle? Seems unlikely.

One day later, the rupee had already surrendered some of those gains, slipping to 44.12 against the greenback during trading hours.

Indeed, uncertainties in the global economy and elevated levels of risk could keep the rupee relatively weak over the next few months - between 43.85 and 44.80 per dollar - despite its recent jump.

There are three main factors influencing the direction of the rupee currently.

The first - and the most important - factor is the fate of the US dollar. The global currency has been troubled by political wrangling over raising the US debt ceiling to avoid a default. At the moment, the markets are worried about whether a deal will be reached before the 2 August deadline, which has put pressure on the currency.

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[caption id=“attachment_50138” align=“alignleft” width=“380” caption=“It seems unlikely that the rupee will be gaining further ground any time soon. Jayanta Dey/Reuters”]  [/caption]The current assumption is that some deal, perhaps a short-term fix, will be managed at the very last minute. That should boost the dollar’s value, at least mildly.

Even if no deal is reached, the most likely scenario is that after an initial thumbs-down by the markets, the dollar will recover because that will trigger an extreme ‘risk-aversion’ behaviour in investors, who will do what they normally do in times of crises of confidence: they will dump emerging-market assets in favour of safe havens, such as dollar-denominated assets. That will cause emerging market currencies, including the rupee, to slide.

The second factor is the euro’s fortunes. The much-touted alternative to the dollar has been swamped by its own problems to think about posing a challenge to the greenback: with the eurozone plagued by sovereign debt woes, most recently reflected by the mega-bailout package for Greece, confidence in the single currency has been dented significantly. A flight to safety from euro investments – if another crisis erupts - will affect emerging financial markets, and consequently, the rupee.

That leads us to the third factor: foreign investment flows into India. Typically, higher interest rates attract investors, everything else remaining the same.

Currently, the difference between Indian and US interest rates (which are below 1 percent) is quite high, luring foreign investors into India’s debt markets. “Investors are able to make incremental yields by investing in Indian debt markets, even after accounting for currency fluctuations,” says Abhishek Goenka, chief executive officer of India Forex Advisors.

Foreign Investors have poured $867 million in debt markets so far in July.

Typically, a currency’s value appreciates with a strong economy. But the truth is the Indian economy isn’t doing well at the moment: high interest rates are actually choking economic growth and demand. Corporate investment has also shrunk, while industrial growth is showing signs of slowing down.

Yet with inflation persisting at stubbornly high levels, the central bank is determined to continue with its tighter monetary policy stance. That means interest rates are likely to remain high in the near future.

“Foreign inflows could increase if the Reserve Bank of India hikes interest rates further,” notes Goenka.

Nevertheless, much will depend on how risk-averse global investors become.

“The risks are elevated in the current environment, but the likelihood of another dip in global growth is unlikely,” says DK Joshi, chief economist of CRISIL.

Ironically, in times of crisis, investors will still seek refuge in the US dollar and dollar-denominated assets, even if the currency itself is struggling with fundamental problems, primarily because there really are no real alternatives to the dollar.

If a deal on the debt ceiling is reached in the US that will also work in favour of the dollar.

Either way, it seems unlikely that the rupee will be gaining further ground any time soon, although a short-term spike can’t be ruled out.

For now, Indian exporters can breathe a sigh of relief.