The Hindu Business Line : Rupee against dollar — It's fundamentals versus sentiment

The Asians, with the global majors, witnessed a sharp fall in their value against the dollar but the rupee was unmoved. What perplexes me all the more is that this complacency in the market exists in spite of all fundamentals pointing towards a weaker rupee.

The RBI released the balance of payments data for 2004-05 on June 30, the summary of which is in the adjoining table. The country's current account flows worsened quite significantly in 2004-05, its trade deficit more than doubled over the previous year. Invisibles grew, but they were nowhere close to matching the jump in the merchandise trade deficit. Contrary to popular belief, oil imports increased by only 41 per cent over previous year, it was the non-oil imports component that pushed up the deficit. As a result, after three years of a current account surplus, India posted a deficit of $6.5 billion in 2004-05.

On occasions more than one, I have heard the rupee bulls say that the capital flows are more than enough to take care of such a small shortfall. If you look at the break up of the capital flows, the picture only worsens. The foreign investments in 2004-05, which comprises of direct and portfolio investments, actually shrunk over the previous year. It was the external loans, which was the primary source of capital flows. Funding the current account deficit through borrowings can hardly be too positive for a currency. What is more worrisome is that a huge chunk of these loans has found its way into the reserves of the central bank.

In other words, corporates are sitting on large foreign currency liabilities, which are unhedged.

Banking capital measures the change in the foreign currency assets and liabilities of the banking system, which in turn gives you a feel for the total leveraged position of the market participants on the current account. As you will notice, over the last four years, banking capital has grown by almost $23 billion. Even after removing the NRI deposit inflows and the foreign currency borrowings of banks, the increase in the unhedged exposures on the current account will be significant.

Two further developments are worth a mention. The trade deficit data for April and May 2005-06 as released by DGCI&S shows a further jump of more than 100 per cent over the same period last year.

Oil and non-oil imports in the two months have increased by 36 per cent and 43 per cent respectively whereas exports have managed a growth of around 20 per cent. Given that the crude prices are significantly higher than where they were last year and are hardly showing any signs of coming off, we are definitely looking at another sharp increase in the trade deficit this year.

The economy continues to grow at a scorching pace, which means that it is unlikely that we shall see much of a slowdown in the non-oil imports as well. Even the current REER at around 108 is far from comforting.

Overall, the picture that emerges is one of fundamentals versus sentiment. All the fundamentals - a widening trade deficit coupled with stagnant non-debt capital inflows, a strengthening dollar, a high REER and a highly leveraged market - are stacked against the rupee but the sentiment continues to be bullish.

The sentiment could continue to be bullish for more time and nothing might happen. But for some reason, if the sentiment turned sour then the move could be quite vicious and cruel.

A good sentiment is self-fulfilling in many ways, because every one is bullish and the price action continues to give every one the requisite comfort, no body disturbs the equilibrium. But if some external shock does shake the complacency, then the market is vulnerable to a big correction.

I frankly don't see any such shock on the horizon for now but it is always good to not loose sight of the fundamentals.

(The author is senior trader, Interest Rates at HSBC Mumbai. The views expressed herein are his own and not necessarily those of his employer.)

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