Why the rupee should harden

August 19, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

The rupee has been uneasy and the stock market nervous since the beginning of this year. The two are not unrelated. For, the fall of the market has been due to absence of FII investment which also deprived the currency market of dollar supply. The outflows more or less matched the inflows and the rupee, with corresponding fluctuations, ended up in August where it had started in January.

The week following Aug 5 was significant. The U.S. lost its AAA credit rating but it was the rupee that weakened against the dollar. Perhaps from panic. The dollar still dominates because there is no other currency the central banks can trust. For a time, there was a scramble for Swiss francs and Canadian dollars.

But these countries and the volume of their currencies are too small for them to be an alternative to the dollar. For the present, the dollar will rule the roost and the rupee-dollar exchange rate will be governed by the currency market as it did before.

The market for the dollar is influenced by supply and demand forces in the absence of RBI intervention. In the last six months, the RBI left it to the market to decide the exchange rate and the rupee fluctuated in the range 44-45 to the dollar. The rupee had ruled strong in 2007-08 just before the U.S. financial crisis.

The crisis did not result in a weaker dollar but a weaker rupee. That was because of the $13 billion outflow of FII investment. The latter is an important driver of rupee-dollar exchange rate because it becomes a component in demand for or also supply of dollars to fund the net trade balance.

Surprisingly, exports have been expanding at the rate of over 45 pct per year since April and even overtaken the rate of growth of imports. This is not a flash in the pan but reflects strong undercurrents that are likely to persist. The trade deficit which was $37 billion in the quarter July-September dropped to $31 billion in the quarter April-June. Besides, oil prices are down and trade in services is in surplus to the extent of $4 billion a month.

That can force the rupee up if capital inflows are in tact. FII inflows have been uncertain but, if the U.S. remains indifferent to growth, FIIs will return as they did in 2009-10. FDI at $5.6 billion in June was the second highest in any month so far. External commercial borrowings also peaked in June. The capital inflows are strong and will more than match the current account deficit with the RBI adding a few billion dollars to its reserve kitty.

The rupee should therefore regain its poise. But what keeps it down is the high rate of inflation. It remained weak at 45.6 to the dollar last year in spite of $31 billion net FII investment. If inflation tapers down to 6 pct by December, the rupee will harden to less than 44 to the dollar.

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