The Hindu Business Line : Re: Further strength ahead?

Chennai May 28 Double-digit movements in currencies are normal in the international markets. Not so in the Indian rupee market. Therefore, when the rupee moves more than 10 per cent in the space of a few weeks, more than eyebrows are raised.

At its current levels of 40.60 to the dollar, the rupee is a stunning 14 per cent up in the past 10 months (from 47.05 levels in July last) and half of that around 6 per cent has come in the past month and a half alone as the Indian currency raced from the 43.20 levels.

The speed of the move has surprised even rupee bulls expecting a more gradual move up in the currency. Its latest levels make the rupee a frontrunner for best performing Asian currency in the past year beating the Thai baht which has risen around 13 per cent against the dollar.

So, what is happening and what lies ahead?

Revealing statistics

It is common knowledge that the proximate cause of the rupee's recent rise is the Reserve Bank of India refraining from active market intervention in the dollar's support.

The statistics here are quite illuminating. Between April 13 and May 18, the foreign currency assets of the RBI went up by only $640 million. In that period, the rupee has moved up from 43.20 to 40.60 — a 6 per cent move. Against that, between mid-February and mid-April, the RBI's foreign currency assets went up by a sizeable $14 billion — from $181 billion to $195 billion. The rupee, reflecting the high level of RBI intervention in this period, moved up only by a modest 2 per cent - from 44.05 to the 43.20 levels.

It is also known that the RBI is keeping off market intervention to avoid the creation of what could be excessive rupee liquidity which could worsen the inflationary pressures in the economy.

`Tactical or strategic'?

The more important question is if the RBI's greatly restrained market intervention is a tactical shift or does it represent a more fundamental change?

The answer to this question will set the pace for the rupee in the period ahead. Indeed, from a fundamentals viewpoint, the direction of the rupee's move does not seem to be in doubt. The rupee appears to be on a secular move up but the stance of the RBI on exchange market intervention could be a crucial determinant of how fast that move is going to be.

A study of the issue indicates that while it may not be a strategic shift in RBI policy, the central bank's recent abstinence from active forex market intervention (buying dollars) may also not be an ephemeral development. A strategic shift in RBI policy means the central bank refraining totally from forex market intervention for all time to come and that is not on the cards any time soon, if at all.

The RBI's decision to stay off the markets in the past month and a half is only a tactical shift but this could last long enough for the rupee to appreciate well above the 40 levels.

In its bid to slow the economy down to a more sustainable pace, it is likely that the RBI has shifted gears in favour of the exchange rate channel for the present.

Broad money (a key parameter monitored by the RBI) is growing currently y-o-y at 20 per cent, well above the RBI's preferred range of 17/17.50 per cent, but lower than the 22 per cent rates seen at the end of March when the RBI announced its last package of monetary tightening measures.

Rise in the WPI y-o-y has also moderated to the 5.5 per cent levels mid-May from the 6.5 per cent levels seen end March. Bank credit growth is also slightly lower at 27 per cent y-o-y as of early May against 29.50 per cent in mid-March.

Therefore, it is possible that observing a slowdown in the rate of broad money expansion, the credit aggregates and a moderation in headline inflation, the RBI is allowing more time for the previous rounds of monetary tightening to play out fully.

In the meantime, it is not weakening the (continuing) impact of the previous rate hikes by buying dollars and creating fresh rupee liquidity at this juncture. This possibly explains the RBI's absence from the forex markets in the past month and a half.

Pushing down inflation

The combined impact of the previous rate hikes and the non-creation of fresh primary liquidity could help in pushing inflation lower and ensure that the recent softening in headline inflation is not merely a base-effect (high base of the previous year) induced phenomenon but is sustained well into the second half of the year.

Enduring success with this tactical shift in inflation management could provide some relief on domestic interest rates in the second half of the year.