Holding the 56.11 support level is crucial for the rupee

By George Albert

The US dollar - Indian rupee (USD-INR) pair has hovered around support for a long time, unable to catch a sustainable bounce. In the week to 24 May, it briefly breached the 56 level to reach 56.04 before dropping back. In case the 56.11 level is broken the pair can go all the way up to 57 levels.

The INR has not been able to recover from its inherent weakness against the dollar. Let us look at a few factors that should have worked in favour of the rupee but it has not. First, the high interest rate differential between the US dollar and the Indian rupee. With the US dollar paying nearly zero interest, the rupee should have been a prime candidate for carry trades.

Carry trade is a situation where people sell the low interest rate currency in favour of the high interest rate one. So in this case investors should have bought the Indian rupee by selling the dollar to earn the higher interest rate. The demand for the rupee then pushes up its value against the US dollar. In fact, the Indian rupee earns a higher interest rate than euro and yen too, but still does not command a premium.

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[caption id=“attachment_814591” align=“alignleft” width=“380”]  With the Fed looking at tightening interest rates what will it mean for the rupee? Reuters[/caption]

This is a sad state for the INR. One of the reasons could be that real interest rates in India are negative given the inflationary situation - though this appears to be abating. This essentially means that the real value of the rupee even after paying the high interest rate gets eroded each day. Inflation, on the other hand, is very tame in the US.

The factor that shows the inherent weakness of the INR against the USD is that the quantitative easing by the Federal Reserve has no discernible impact on the value of the rupee. The Fed has been printing the dollar in gay abandon and the consequent increase in the supply of the greenback should have reduced its value substantially against the Indian rupee. But nothing of the kind has happened.

On the contrary, the INR has continued to be weak. One of the reasons could be the continued growth in the Reserve Bank of India’s deficit financing. So the increase in the supply of dollars due quantitative easing is being matched by an increase in the INR’s money supply due to deficit financing.

Now we are reaching a situation where there is debate in the Federal Reserve on whether to ease the dollar printing presses and reduce the liquidity accommodation to the economic system. Increased talks on tightening the dollar supply will surely lead to a rise in the greenback’s value and a fall in the rupee’s. It could also lead to a fall in the stock market, which may result in a selling spree by foreign institutional investors in India. That will not only push the Indian stock markets down, but a demand for dollars to repatriate profits will cut the value of the rupee.

The best way to strengthen the INR is to unleash a supply side revolution with lower taxes, less regulation and a small government. Such a policy will unleash the entrepreneurial spirits of the Indian economy which will increase the production of goods and services. Increased supply will mean lower prices, which essentially means the real value of the INR increases.

Till we see a real increase in supply of goods and services, we should expect long term weakness in the INR. The low of the INR was a little above 57 against the USD. If that level is breached there is no support level in price and we could see a sustained long term drop in the currency.

The author is Editor of www.capturetrends.com