The rupee has become the joker in the pack once again. Not a long time back we had analysts talking of the rupee appreciating with serious talk of it reaching the 50 to a dollar mark and the debate was on how soon this would be a reality. Going one step forward economists were already discussing on what RBI should do to stop the appreciation given that exports would be impacted. Everyone seemed to be gung ho about the India story and the fact that exports looked positive between January-March added to the conviction.
The month of May has been more than interesting for the currency market with all attention on the falling rupee (depreciation of 5.1% in one month). On the face of it, there appears to be nothing new really happening—we still have our normal serious CAD problems but FIIs are generally positive with more inflows than outflows. Why then is there this new phase of panic? There appear to be two sets of factors here. The first is physical numbers that are driving the rupee and the other is pure sentiment. The demand-supply of dollars is important as it is fundamental in nature and actually drives the currency. Exports do not quite appear to be growing and demand for imports has gone up. The twin causes remain the same—gold and oil. While the fall in gold prices gave us reason to cheer, our natural tendency to increase demand when the price falls has caught up, thus leading to demand being sustained. The government and RBI have tried all methods to control this demand, with limited success. While demand for gold coins or credit to buy gold can be curtailed through fiat, the same does not hold when one buys jewellery. This has been a concern and a tough one to crack. The move to raise the duty rate to 8% is pragmatic and will help as the only way to stem demand is to make the price unattractive. Global crude oil prices appear fairly stable, but the problem appears to be with rising demand which has caused importers to rush in to buy dollars to meet this requirement. One cannot be too sure of what is happening on the other front—invisible account, but FII investments have been positive for most of May. In fact, between May 1 and June 4, there have been net outflows on 7 of the 25 working days. But, given that there has been a decline in the country’s forex reserves by around $2.5 billion, this could be the ultimate ‘physical’ factor working in pushing the rupee down. The other related factor is the stronger dollar. The dollar has actually strengthened against most of the emerging markets currencies in May, which means that what is happening to the rupee is not really out of the ordinary. The strength of the dollar may be attributed more to the positive prospects of the US economy, though institutions like the IMF are still guarded about the final outcome. The news that QE may be aborted earlier than expected has also made the dollar appear stronger. And this is where sentiment plays a role because once the world believes that QE3 will end earlier, it implies that there will be less dollars available for investment purposes, which, in turn, provides a boost to the currency and the emerging markets get affected the most. Therefore, depreciation of currencies of countries dependent on the US for capital flows has witnessed sharper depreciation than most of those of the developed countries. In the forex market, sentiment is always self-fulfilling and hence when the market expects the rupee to fall, importers rush to buy dollars while exporters hold back their earnings to the extent possible to realise higher returns. What is moving sentiment then? The first is panic where reiterating the need to control gold imports exacerbates sentiment, as the market takes it that this issue is insurmountable. Second, RBI has been talking of the CAD being a major threat, which is interpreted to mean that RBI will not cut interest rates which weaken the rupee further. Also, such an announcement is also taken to mean that RBI would probably not really intervene in the market to defend the rupee to provide a competitive edge to exporters. This makes the possibility of unchecked depreciation more credible, driving down the rupee further. Can anything be done to stem this fall? The answer is ‘not really’. The best that can be done is to have limited comments on the external front as any statement is taken out of context to add to the panic. While expressing concerns over gold imports or the CAD are legitimate, too much of emphasis adds to the emotion. One may not be able to control the currents flowing from global markets on the action to be taken or not taken by the Fed, and hence sentiment will still continue to drive down the rupee. Based on fundamentals, there could be little that could be done given that imports are largely free and exports are driven more by external conditions than from the supply side. At the policy level, there could be some urgency shown in moving ahead in the area of FDI or liberalising ECB limits further, though there are arguably pitfalls of building up our external debt stock if companies borrow more from the global markets. FDI liberalisation, per se, may improve sentiment in the very short run, though to really make an impact, we need to see more dollars actually coming in which will, of course, happen over a period of time. The issue with the fall of the rupee is that we are ourselves not sure of how RBI will behave. While RBI has always maintained that it does not target an exchange rate, the market always creates a number and then builds expectations around until such time RBI actually intervenes to stabilise the rupee. RBI will have to relent at some time because a depreciating rupee also means higher imported inflation. Therefore, volatility may be expected to prevail until such time RBI actually intervenes, which though not desirable, may be the last resort. And surely this market will wait for this action.
The month of May has been more than interesting for the currency market with all attention on the falling rupee (depreciation of 5.1% in one month). On the face of it, there appears to be nothing new really happening—we still have our normal serious CAD problems but FIIs are generally positive with more inflows than outflows. Why then is there this new phase of panic? There appear to be two sets of factors here. The first is physical numbers that are driving the rupee and the other is pure sentiment. The demand-supply of dollars is important as it is fundamental in nature and actually drives the currency. Exports do not quite appear to be growing and demand for imports has gone up. The twin causes remain the same—gold and oil. While the fall in gold prices gave us reason to cheer, our natural tendency to increase demand when the price falls has caught up, thus leading to demand being sustained. The government and RBI have tried all methods to control this demand, with limited success. While demand for gold coins or credit to buy gold can be curtailed through fiat, the same does not hold when one buys jewellery. This has been a concern and a tough one to crack. The move to raise the duty rate to 8% is pragmatic and will help as the only way to stem demand is to make the price unattractive. Global crude oil prices appear fairly stable, but the problem appears to be with rising demand which has caused importers to rush in to buy dollars to meet this requirement. One cannot be too sure of what is happening on the other front—invisible account, but FII investments have been positive for most of May. In fact, between May 1 and June 4, there have been net outflows on 7 of the 25 working days. But, given that there has been a decline in the country’s forex reserves by around $2.5 billion, this could be the ultimate ‘physical’ factor working in pushing the rupee down. The other related factor is the stronger dollar. The dollar has actually strengthened against most of the emerging markets currencies in May, which means that what is happening to the rupee is not really out of the ordinary. The strength of the dollar may be attributed more to the positive prospects of the US economy, though institutions like the IMF are still guarded about the final outcome. The news that QE may be aborted earlier than expected has also made the dollar appear stronger. And this is where sentiment plays a role because once the world believes that QE3 will end earlier, it implies that there will be less dollars available for investment purposes, which, in turn, provides a boost to the currency and the emerging markets get affected the most. Therefore, depreciation of currencies of countries dependent on the US for capital flows has witnessed sharper depreciation than most of those of the developed countries. In the forex market, sentiment is always self-fulfilling and hence when the market expects the rupee to fall, importers rush to buy dollars while exporters hold back their earnings to the extent possible to realise higher returns. What is moving sentiment then? The first is panic where reiterating the need to control gold imports exacerbates sentiment, as the market takes it that this issue is insurmountable. Second, RBI has been talking of the CAD being a major threat, which is interpreted to mean that RBI will not cut interest rates which weaken the rupee further. Also, such an announcement is also taken to mean that RBI would probably not really intervene in the market to defend the rupee to provide a competitive edge to exporters. This makes the possibility of unchecked depreciation more credible, driving down the rupee further. Can anything be done to stem this fall? The answer is ‘not really’. The best that can be done is to have limited comments on the external front as any statement is taken out of context to add to the panic. While expressing concerns over gold imports or the CAD are legitimate, too much of emphasis adds to the emotion. One may not be able to control the currents flowing from global markets on the action to be taken or not taken by the Fed, and hence sentiment will still continue to drive down the rupee. Based on fundamentals, there could be little that could be done given that imports are largely free and exports are driven more by external conditions than from the supply side. At the policy level, there could be some urgency shown in moving ahead in the area of FDI or liberalising ECB limits further, though there are arguably pitfalls of building up our external debt stock if companies borrow more from the global markets. FDI liberalisation, per se, may improve sentiment in the very short run, though to really make an impact, we need to see more dollars actually coming in which will, of course, happen over a period of time. The issue with the fall of the rupee is that we are ourselves not sure of how RBI will behave. While RBI has always maintained that it does not target an exchange rate, the market always creates a number and then builds expectations around until such time RBI actually intervenes to stabilise the rupee. RBI will have to relent at some time because a depreciating rupee also means higher imported inflation. Therefore, volatility may be expected to prevail until such time RBI actually intervenes, which though not desirable, may be the last resort. And surely this market will wait for this action.
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