Expert Zone

Straight from the Specialists

The fall of the rupee

September 28, 2011

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

Since the beginning of September, the rupee has dropped 11 pct, most of the fall coming in the third week. That has inflated the cost of essential commodities, like petroleum products, and inflated debt servicing of external commercial borrowings. Naturally, this has raised questions. Should the RBI have intervened?

Actually, the rupee should have depreciated long time back because of excessive inflation. Going by the real exchange rate, the rupee should have been down to 48 to the dollar right from the beginning of the year. But it did not. That was because the current account deficit was more than covered by foreign investment, mainly FDI.

The sharp fall of the rupee in September is not because of inflation but the flight of FII investment. In two weeks, FII disinvested $1.5 billion, about half from equity and half from debt. The market which had already become very sensitive to fears about recession in the U.S. and the EU debt crisis, collapsed taking the rupee with it.

The flight of FII investment was not restricted to India but extended to most other emerging market economies. That resulted in the strengthening of the dollar in spite of the imminent recession in the U.S. The dollar appreciated 7 percent against the euro.

The EU debt crisis has created a scramble for liquidity. There is a shift not only from risky assets like stocks but also commodities including gold and silver, to cash. Undoubtedly default in sovereign debt repayment by Greece, with its contagious effect, has dangerous implications for the banking system and the euro. Most likely, the European Central Bank (ECB) will extend assistance to stem the tide and salvage the defaulting members of EU.

The situation in 2008 was similar. The scramble for liquidity led to flight of FII investment which strengthened the dollar against most other currencies. The outflow of FII investment from India in 2008-09 was over $13 billion. This time the outflow, so far, is much less.

The scramble for liquidity will ease if the ECB bails out Greece. Even so, there is threat of recession in the U.S. as also EU. That will not hold back investment. Once liquidity eases and risk appetite increases, FIIs will return to emerging market economies. In 2008-09, the $13 billion outflow was followed by $32 billion inflow into India.

There are reasons why foreign investment will bounce back. First, with impending recession, investment opportunities in the U.S. and EU will shrink and investors will be tempted to look for markets abroad. Second, with recession in the U.S., international commodity prices will drop and lower inflation and possibly interest rate. Both will help rupee crawl up.

The trigger may be the budget. It is likely that FII investment will bounce back in March and provide the missing support to the rupee. In spite of the inflation, the rupee will appreciate. It can be expected that the rupee should be up to 45-46 to the dollar once again in March-April.

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