Don't bet your last dollar on the rupee's rise

The sentiment on the Indian rupee (INR) has changed on a dime. The INR, which was supposed to fall to Rs 60 to the US dollar (USD) a few months back, is now expected to trend well below Rs 50 to the USD. The INR had touched all-time lows of Rs 57 in June 2012 and is now trading at levels of Rs 52 to the USD, a gain of 8.7 percent from lows.

The change in sentiments on the INR has been brought about by many factors, including announcements of quantitative easing by the US Federal Reserve (the Fed is buying USD 40 billion of mortgage-backed securities every month), European Central Bank (the ECB has given itself unlimited powers to purchase bonds of euro nations) and the Bank of Japan (BoJ is purchasing additional USD 126 billion of bonds). Domestic factors that took up INR sentiments include fuel price hikes and allowing more FDI in retail, aviation, insurance and pension sectors.

The currency market swings violently both ways, as it is fully speculative in nature. Hence bearish calls on the INR have now turned to bullish calls. Rs 60 to the USD are turning to Rs 50 and below. The swing in calls is now 16 percent. The question is: has India’s fundamentals improved overnight to change from extreme pessimism on the INR to extreme optimism?

The answer is no. India’s fundamentals have not changed overnight for pessimism on the currency to turn into optimism. The fact that the INR trended towards lows in June 2012 is more on account of currency market behaviour than economic fundamentals while the calls of Rs 50 and below to the USD is again more of currency market optimism than any change in fundamentals.

The market was extremely short at Rs 57 to the USD with speculators running short positions, importers being overhedged and exporters being underhedged. The economic fundamentals of the country in June were a weakening in economic growth. Growth is expected to fall from 6.5 percent levels in 2011-12 to below 6 percent levels in 2012-13, and there’s a question-mark on the government’s fiscal deficit which is expected to overshoot the budgeted target of 5.1 percent of GDP by a wide margin. Plus, we have seen weakening trends in IIP (Index of Industrial Production) growth and export growth with both the data coming in negative in the beginning of fiscal 2012-13.

The economic fundamentals have not changed since June 2012. The IMF pegs India’s growth at levels of 4.9 percent for 2012-13 while other think-tanks have pegged growth in a 5.5-6 percent range. The government will exceed the budgeted fiscal deficit target of 5.1 percent of GDP despite the hike in fuel prices and focus on expenditure control. IIP growth for the first four months of fiscal 2012-13 is negative while export growth is also negative for the first five months of the fiscal.

India’s current account deficit (CAD) as a percentage of GDP was at 3.9 percent as of end-June 2012 against 3.8 percent levels seen in June 2011. India’s foreign exchange reserves have hardly changed from levels of USD 292 billion over the last six months. The ratio of foreign exchange reserves to external debt has come off from levels of 85.1 percent for 2011-12 to levels of 82.9 percent as of end-June 2012. India’s level of short-term debt to total reserves is at 51.8 percent and leaves the country vulnerable to any global risk aversion on emerging currencies.

The change in perceptions about the country on the back of some bold policy moves has helped the INR come back smartly from record lows. However, the case for strong bullish bets on the currency is quite unwarranted and speculators, importers and exporters should not go overboard in assuming the rupee will keep rising. The INR can well trend to Rs 50 to the USD as shorts are still getting out of the market and it may even briefly break the Rs 50 level on short-covering. However, when over-pessimism turns to over-optimism it is a time to reverse optimistic trades.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com , a web site for investors.