Straight from the Specialists
When will the rupee recover?
(The views expressed in this column are the author’s own and do not represent those of Reuters)
The rupee sank to its lowest on Tuesday with pressures from the market and absence of support from the RBI. The fall really began in August and in the last four months took the rupee down 18 percent against the dollar.
Many other currencies also weakened but the rupee underperformed the most because a significant demand supply gap for dollars had developed. There are two important causes for this sharp fall in such a short time. First, the usual inflow of dollars from investment by FIIs had stopped and even significantly reversed.
In the four months since August, disinvestment was more than $2 billion which pushed prices of stocks down and raised the price of dollars up. The fall of the stock market and of the rupee go together because they are two sides of the same transaction.
And why did the FIIs disinvest? It was mainly because of the crisis in Europe which killed risk appetite, driving investors into dollars or gold. Partly also it was because the earnings of companies shrank and caused fall in industrial growth. Profit margins of Sensex companies are at a seven-year low which has brought the price/earnings ratio from 22 to 16.
Second, the pressure on the rupee was intensified by the bulging trade deficit. It increased from $10 billion in September to $20 billion in October. The expected fall of the rupee also gave rise to hedging particularly by the oil companies which are large importers and further inflated demand for dollars.
Whether from disinvestment by FIIs or increase in imports, the demand for dollars shot up; simultaneously supply shrank with drop in exports. That knocked down the rupee much more than the Singapore dollar or Thai baht.
The fall of the rupee, in spite of its adverse consequences, could not be reversed or slowed by the RBI since the intervention would have to be substantial and the sale of dollars would have reduced liquidity in the economy forcing interest rates up further.
Will the rupee recover? That will take time because neither the FII investment nor the trade deficit is likely to improve soon. It appears that the European crisis will not be resolved early since too many countries are facing the dangerous prospect of sovereign debt default.
Hence, investors are unlikely to renew investment and imports are unlikely to pick up soon. The only reason for the FIIs to take interest in Indian stock is that prices have dropped far too much which make it a good buy.
The current price/earnings ratio is comparable to the ratio in Malaysia, New Zealand or the U.S. In the international context, Indian stocks may no longer appear overpriced, more so in dollar terms. Hence, there should be return of FII investment if the European crisis does not worsen. It can, therefore, be expected that the market should recover and rupee harden before April if inflation weakens and the budget is constructive.