Yuan devaluation effect: Will 65-66 be the new normal for the rupee?

With the rupee coming close to the Rs 67 per dollar mark, the question is how low will it go? In fact there has been a protracted period of tranquility and stability in the rupee as it ranged between Rs 63-64 up to end July and also early August. It was only when the Chinese central Bank had devalued the Yuan that the rupee tumbled along with all the other global currencies causing panic in the markets.

At this stage it is hard to conjecture as to where will the rupee go. The best estimate or forecast would be to use the ‘adaptive expectations’ model and look at a number of between 65-66, which can be the new normal on the assumption that every shock leads to a new level which will be higher than the earlier one. Given that on an average the rupee has moved between 4-5 percent downwards such a projection does not look unreasonable presently. This is because there has been a call by market players for the RBI to allow the rupee to depreciate so as to ensure that exporters continued to get an edge. That was when the rupee was at Rs 64 per dollar. With nature taking care of this movement, the pressure on RBI is less and it may have to only intervene when it thinks that things are going out of hand.

If we look at the fundamentals, then it appears that the rupee should be strong. In simple terms if the forex reserves are increasing which is the case today, then there are more dollars coming in than going out and the rupee should hence strengthen. As the increase has been marginal, the rupee should remain stable. But this can be distorted in case there are dollars being absorbed by the RBI or injected in the market. This is how the rupee is balanced in terms of value. If the net inflows are taken by the RBI then the rupee will not appreciate, which has tended to be the case this year.

How is this happening? Exports have been declining, as the global economy is still in a recovery mode and there are few signs of a strong pick-up. The recovery will be at best, feeble. However, with imports also declining with global crude and commodity prices moving downwards, the balance of trade has been stable. Add the other current inflows like software receipts and remittance, and the current account deficit should be quite low at this point of time. Foreign investment flows have been high with FDI crossing $10 billion in first quarter and around $19 billion since January while FII flows have been marginally positive this year which has resulted in forex reserves increasing by around $13 billion in the financial year.

The fall of the rupee is evidently due to the Chinese devaluation that has affected all countries. Now one is not sure as to how permanent this depreciation is and whether it will be ongoing given that the rate is to be adjusted every day with the previous evening’s close. The Yuan has already touched 6.40 per dollar which was the equilibrium rate assumed by the market when the devaluation set in. It is anybody’s guess today whether it will fall further as the motivation for such devaluation was to spur exports, which may need a harder push.

Now the market will be guessing several things. First, exporters will like to hold back their earnings so that they can convert their earnings at a higher rate. Second, importers will like to rush in and buy dollars lest they have to pay more at a later date. These two will distort the fundamentals of demand and supply leading to a weaker rupee. Third, the NDF market will get a boost and transactions could shift overseas as was the case in 2013 when there was a run on the rupee. Fourth, with excess liquidity in the system, this may be the right time for banks to take speculative positions in the market. Fifth, the RBI’s actions will become a cause for further volatility in the market as the players try and guess the rate the RBI is comfortable with.

Therefore, it will be essential for the RBI to provide some guidance as the market is always self-fulfilling and the first four factors pointed out will automatically ratchet down the exchange rate (meaning thereby that the rate could move upwards of Rs 67 per dollar).

Is the situation different from that in 2013? To a certain extent there is a close resemblance as even at that time it was caused by the Fed talking of tapering. This time also the trigger is a global shock which appears a bit more real as it a result of the Yuan tumbling downwards taking with it the stock markets. A Chinese slowdown can be as devastating for the markets as a perceived US recovery which caused the Fed to rethink the quantitative easing programme. The similarity ends here as the balance of payments appears much stronger than it was in 2013 when gold imports had combined with high crude oil prices to spoil the party. Today, both of them are on the decline and hence the pressure on the central bank is that much lower.

At the theoretical level, the proponents of the REER theory (real effective exchange rate) would be pleased at this movement. The theory says that the real effective rate is the ratio of inflation in India compared with the trading partners multiplied by the nominal exchange rate. As the REER comes to above 100 it has been argued that the rupee has to depreciate to go back to normal. Therefore, the current nominal depreciation would help to correct this anomaly.

Anecdotally speaking every phase of currency volatility becomes an episode that lasts for some time –- at least a month. As it is coming from the Great Wall, one cannot be sure of how long would this persist. The pressure on corporates is palpable as they need to hedge their risks if this movement is more permanent. But given the forward premium being 7.5 percent for 1-3 months, it is a tough call especially if the rupee will return to equilibrium earlier or falls by less than is expected. We are back to volatile times.

(The author is chief economist, CARE ratings. Views are personal.)