Will rupee fall or rise in 2015? Don't be surprised if it's the latter

This calendar year, now coming to an end, the rupee has lost less than some of the other emerging market currencies, losing around 3 percent against the US dollar since December 2013, as against the 6.5 percent loss of both the Malaysian ringgit and the Taiwanese dollar, and 4.3 percent and 4.1 percent for the Singapore dollar and the South Korean won (see table). The Chinese yuan and Indonesian rupiah did better, but the former is a managed currency, and the latter may now face headwinds as oil and coal prices are weak.

Today (29 December), the rupee is ruling weak around 63.65 to the US dollar, but the chances are it will steady itself in the new year – and possibly even rise.

But here’s the surprise: we tend to notice the rupee’s value only against the US dollar, and thus it appears to have slipped this year. But the reality is the rupee gained against many other convertible currencies like the Swiss franc, the euro, the British pound and the Japanese yen. The rupee gained the most against the yen (9.9 percent) and the euro (8.8 percent), two economies on the brink of deflation, and by 7 percent against the stronger Swiss franc, and 2.9 percent against the British pound.

So the reality is the rupee has been rather strong this year, not weak, even though it value against the dollar makes it appear weak. So the chances of the rupee doing as well, if not better in 2015, cannot be ruled out.

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To understand why, we have to look at the fundamental factors that drive a currency’s price. These include the current account deficit and foreign exchange inflows, the domestic inflation rate, interest rates, and overall government policies (whether they are friendly or unfriendly to foreign investors). Then, of course, is the imponderable: how other economies fare. If they fare worse than India, the rupee will benefit.

This year, all these factors have been positive for the rupee, with the current account deficit coming down, inflation falling, interest rates remaining high and the government opening up many sectors for foreign investment, including defence and railways.

If the rupee still lost 3 percent this year, there can be only one major reason for it: it is being seen in the wrong company. Global investors tend to list India as an emerging market economy, and so India cannot escape this branding. So when the sentiment is against emerging market economies, India will decline with them against the US dollar.

As the US economy grows strongly this year, the chances are we could again slip against the dollar and rise against the rest.

However, usually, the market learns to distinguish between apples and oranges over time, and there is now some evidence that this is beginning to happen. As this Mint report, quoting strategists at Goldman Sachs shows, despite the sharp fall in oil prices, which makes India, which imports 80 percent of its oil, a major beneficiary, the rupee is being “weighed down by a ‘generalised shock’ across emerging-market currencies…There’s room for it to recover.”

Logically, given India’s better macro fundamentals, the rupee should behave in one of the following ways in 2015: if major emerging market currencies continue falling, India will fall less or remain stable; if others remain stable against the US dollar, the Indian rupee could actually appreciate marginally.

The following are the key conditions needed for the rupee to stay stable, or even rise against the dollar.

#1: FII inflows need to remain strong. This means about $40-50 billion of inflows into debt or equity. This seems likely as long as the reform momentum does not flag. By February-March, when we know what the budget brings and the fate of several legislation now stuck in the Rajya Sabha, we can be clearer on FII attitudes to India.

#2: The RBI must cut rates only slowly to keep real interest rates positive. Currently, with CPI inflation at 4.38 percent in November and WPI at zero, real interest rates on government securities are clearly positive. No one is expecting interest rates to fall by more than 0.5-1 percent in 2015, which means real interest rates in India will stay attractive in the foreseeable future.

#3: Oil prices must remain in a zone – say under $80 a barrel for most of 2015. This seems possible, though no one can predict prices that far ahead.

#4: Domestic inflation must remain subdued, even if growth starts recovering. This seems probable, too. However, Uday Kotak told The Economic Times in an interview today (29 December) that he expected India to grow at 5.3 percent in 2014-15, and “we will be lucky if, in FY16, we reach 6 percent…”. He believes that even if we don’t screw up, there is still the global deflation to worry about.

#5: The current account deficit must remain within 2 percent of GDP. This means exports have to grow positively, and import growth must not suddenly spike due to lower costs. This largely means that we should not allow oil prices to fall too much back home, and tax it more to prevent a sudden surge in demand.

Depending on how these factors play out, one can cautiously predict that the rupee is not on a downward trip in 2015. In fact, it could even rise.

(Data support by Kishor Kadam)