The Hindu Business Line : Global meltdown weighs on the rupee

Bangalore, Dec. 29 For the Indian rupee Circa 2008 was not exactly very good. It was a year of extreme volatility and the rupee has shed over 20 per cent against the US dollar since April this year. The rupee descent was partly on account of global phenomena, where over-leveraged investors, hit by the financial sector meltdown, unwound and sought out safe havens, in particular the dollar.

FII flight

The unwinding had its impact on the domestic capital account. Non-debt capital reversed flows for the first time since the beginning of this decade. Foreign institutional investors panicked and fled from the Indian markets to shore up their parents embroiled in ‘deleveraging’ and carry trade reversals.

FIIs pulled out about the equivalent of $7 billion (about Rs 35,000 crore) since the beginning of this fiscal, shaving off over 50 per cent of BSE Sensex, leaving domestic investors deeply bruised. In 2007-08, FII inflows amounted to $29 billion.

The bail-out packages by the US Federal Reserve, alongside 10 quickfire reductions in the key Federal Funds rates to a band of 0 and 0.25 per cent did little to halt the panic among the US banks, insurers and investment banks.

Into T-bills

After the last meeting of the Federal Open market Committee, non-debt outflows from India amounted to $8.8 million. If there were some positive flows, it was into debt, mostly T-bills, for purely booking treasury profits.

Moreover, there were little External Commercial Borrowings (ECB) flows so far this financial year. Most corporates that had lined up approvals for cross border debts were forced to shelve their proposals. This year, the spreads were unusually high, as high as 600 basis points.

Starved of cross-border funds, corporate borrowings translated into high domestic credit offtake and intense pressure on the domestic money markets. The tightness pushed the Reserve Bank of India to act.

RBI measures

Since October this year, the RBI pulled down the Cash Reserve Ratio to 5.5 per cent in November 3 from a high of 9 per cent in August 2008. This was a complete reversal of the RBI measures from last year, when the CRR went through graded hikes that were kept up till August this year, to contain money supply and combat inflation. The rapid pace of CRR reductions indicated that inflation was less of a worry in a regime of hedge fund collapses and declining commodity prices. Increasing domestic liquidity availability and sustaining GDP growth took priority. The current account also came under pressure, particularly of oil import requirements. Oil companies’ credit requirements escalated during the year as import prices soared to a high of $142 a barrel in July.

The oil price spikes prompted the RBI to react and release foreign exchange from the reserves. The release was done through Special Market Operations, purchase of oil bonds from refineries at a discount and simultaneous release of equivalent foreign exchange. The objective was to ensure exchange rate stability.

The RBI’s market interventions for defending the rupee, however, shrank the foreign exchange reserves by at least $50 billion over the last five months. The interventions failed to stop rupee from breaching the Rs 50- mark. It, in fact, touched a low Rs 50.03 to the dollar. But as the rupee retreated, importers consistently took forward cover. For most of part of the financial year, it was the exporters who took forward cover.

Both parties preferred the Over the Counter (OTC) forward markets as opposed to currency futures market where turnover remained abysmally low at $225 million per day. OTC volumes comparatively were $18 billion per day.

Outlook

The outlook for the rupee does not appear positive, given this trend. There are few reasons for any major appreciation next year. HDFC bank’s Chief Economist, Mr Abheek Baruah, says, “We are likely to see the rupee-dollar exchange rate in the Rs 49-51 range.”

The forecast comes despite oil prices dropping to a low, in view of the US recession. The only factors that could change the exchange rate equation are the capital and current account flows.

There is currently little reason for optimism on capital account flows on the non-debt side. This is because the current pace of financial deleveraging is far from complete.

Secondly, ECB flows are also unlikely at this juncture, since global risk appetite is yet to improve. The only inward flows now likely are in the form of banking capital, including non-resident bank deposits. The NRI remittances are at accelerated pace sine the beginning of last month, but they are unlikely to match the scale of FII institutions.

Current a/c concerns

On the current account, although oil payments have reduced, new problems now appear likely in the form of shrinking export markets for Indian goods.

In addition, some Indian exporters are faced with payment defaults/ delayed payments from cross border importers. Reflecting the downside sentiments are the non- deliverable forward markets and the forward premia.

For most period of last year, the NDF (cross border forward foreign exchange markets in emerging market currencies where settlement is mostly in US dollar at the end of 30 days) rates were mostly at discounts of 5-10 per cent to the domestic market spot rate.

This year, NDF rate, pre-Christmas, was about 5 per cent premium to the domestic spot rates. Moreover, six-month forward rates were about 4 per cent.

Clearly the pointer is only one direction for the rupee against the dollar next year — down, other things remaining equal of course!