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S. Balakrishnan

LONG has the rupee provided a living for forex dealers, brokers and consultants — because it was always a one-way bet. The question was not whether it would depreciate but how much. There were some periods of stability — the early eighties and parts of the first half of the nineties come to mind — but it was always a steady journey downwards.

Suddenly, in the last few months, it has all changed. The rupee is on the rise. From Rs 49+ levels, it has appreciated to a little over Rs 48. It has been one continuous unmitigated upward movement. The rupee, as is well known, is not convertible on capital account. Thus, interest rate differentials between rupee and the US dollar do not entirely drive forward rates. However, there is much greater convergence now between the actual and theoretical forward rates because the RBI's liberalisation has brought about a high degree of integration between domestic money and forex markets. Interest rates have been freed and banks are now allowed to invest 25 per cent of their Tier I capital in foreign assets. They can also borrow the same amount in offshore markets for rupee assets. These measures have considerably dwindled and narrowed arbitrage opportunities between the dollar and rupee.

As far as the spot market is concerned, the exchange rate is determined by the demand-supply balance. Here a multitude of factors are at play. Among them are trade flows (import payments and export receipts for goods and services), Government transactions on capital and current accounts, private capital flows (investments and remittances) and proprietary trading by banks. It is obvious that, at present, spot dollar supplies are far more than demand leading to the rupee's appreciation. Market sources say that, but for the RBI's dollar buying, the rupee would be higher, possibly in the Rs 47 range.

The collapse of dollar interest rates has obviously a lot to do with the rupee's strength. While Indian interest rates too have come down sharply, rupee deposits still yield a good 5 per cent more than those in dollars. The RBI's rules now allow non-resident deposits to move freely from dollar to rupee and vice-versa. This, coupled with surging forex reserves, has given NRIs new-found flexibility and confidence and prompted them to take advantage of the much more lucrative returns on fixed-income rupee assets.

Will the rupee continue to enjoy good times? Exports are turning in a good performance and software seems to be on the road to recovery. Private transfers have been on an upward trajectory for quite some time. There is no reason to think that all this will change.

Are there any caveats? Oil prices are one. A jump in crude would significantly increase dollar demand in the spot market and dampen the rupee. Another source of instability could be portfolio shifts — private capital can just as easily flow out as it can flow in, if more attractive dollar investment opportunities arise. Possible sources are a sustained resurgence in the US stocks and bond yields, which will make rupee assets that much less profitable.

In future, the rupee's vulnerability will come not from the country's current account but reversible capital flows, given the present situation of fungibility of dollar and rupee assets and rapid investor shifts between currencies in fast-changing financial markets. But the RBI's reserves appear to give it sufficient ammunition to deal with such events.

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