The rupee at a crossroads

May 19, 2014

(Any opinions expressed here are those of the author and not of Thomson Reuters)

The rupee was tossed around quite a bit in the last 10 months. It dropped to a low of nearly 69 to the dollar, creating an economic crisis, before it recovered and is now at 59-60. The threat is not that it may drop once again, but that it may appreciate further and upset the economy in other ways.

Why would the rupee appreciate? Because there are expectations the Narendra Modi government will facilitate development and enable the economy to get back on course. This is what drove the Sensex beyond 25,000. But the currency market was more stable in spite of the huge inflow of $2.2 billion in 10 trading days of May.

That is because the currency market can be better managed with intervention by the Reserve Bank of India. The RBI can purchase excess dollars and build foreign exchange reserves instead of leaving it to the market to price down the dollar and encourage additional imports.

The rupee-dollar exchange rate is critical. A harder rupee makes imports attractive to Indian consumers and exports more expensive for foreign buyers. With the inflation that we had in the last three years, prices of most of our exportable goods have been marked up. To some extent, this has been reversed by the fall in the rupee against the dollar to 59-60 from 45. With the rupee correction, the competitiveness of Indian exports has been restored. Even so, exports have not picked up because the major importing countries have been in a stalemate.

With the new government, reforms are expected to resume and policy priorities are likely to change to encourage growth. At the same time, there may be greater emphasis on governance to ensure that policies and projects are efficiently implemented. Quite possibly, foreign investment policy, except in retail, will open up and the inflow of foreign direct investment will accelerate.

Investment by FIIs will be influenced by the extent to which the U.S. Federal Reserve cuts quantitative easing. But as indicated by Janet Yellen, interest rates will be near zero for the foreseeable future. The compelling attraction for FIIs would be the initiatives of the new government to set new targets with reformed policies. FII investment in debt and equity will increase and the Sensex will shoot up.

It is possible that the currency market in India will be oversupplied with dollars, which can harden the rupee. It is this possibility that the RBI should guard against. The excess dollars should go into the foreign exchange kitty rather than cheaper imports which may inflate the current account deficit and drive the rupee down again.

The rupee is now at a crossroads where any further increase in the currency against the dollar will make it over-valued and will adversely affect exports. Once industrial growth picks up, imports will increase much faster than exports leaving the current account deficit to be funded by FII investment. At that point, RBI intervention will become unnecessary.

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