The Hindu Business Line : Rupee: Will it defy global dollar upswing?

Defying many predictions of a disruptive breakdown, the dollar is up noticeably against all major currencies. A burgeoning trade deficit, narrowing interest rate differentials between the US and India, and a deceleration in capital flows form the foundation for many bearish forecasts about the rupee. Many market participants have made a negative correlation between the movements in US interest rates and the magnitude of capital flows to India — a relationship that, T. B. Kapali argu es, is not supported at all.

ONE OF the highlights in the global financial markets this year has been the broad-based dollar rally. Defying many predictions of a disruptive breakdown (in continuation of its extreme weakness in Q4 of 2004), the US unit is up noticeably against all its major global counterparts. And more dollar strength seems on the cards as we near the close of Q4 in 2005 and step into a new year.

Venturing further, it is even possible that it is at the start of a medium-term rally, if the historical movements in the past three decades (indicating a cyclical pattern of strength and weakness) are any indication of its performance in the ensuing period.

This prognosis is tempered by the fact that the global political environment is marked by a high level of tension. Geo-political developments could have unpredictable consequences for financial markets. It is also possible that the change of guard at the US Federal Reserve (with Mr Ben Bernanke to take over from Mr Alan Greenspan in January) could have some moderating impact on the dollar strength.

Nearer home, the rupee too has come under intense downward pressure in recent weeks. Inevitably, this fall has thrown up the question whether it is also the start of a period of weakness against the dollar. It is pertinent to note that the rupee's strength over the past three years (from its May 2002 low of 49.05) broadly coincided with a general, global, environment of dollar weakness.

Bearish market forecasts: Another view

A burgeoning trade deficit, narrowing interest rate differentials between the US and India, and a deceleration in capital flows form the foundation for many bearish forecasts about the rupee. Many market participants have posited a negative correlation between the movements in/level of US interest rates and the magnitude of capital flows to India.

In that negative correlation framework, the capital account cushion to the current account deficit is seen considerably weakened as US interest rates rise, leading to a downward correction in the rupee. But such a correlation between the level of US rates and the magnitude of capital flows to India is not supported at all. Neither the pattern of capital flows in the immediate past nor the pattern of capital flows/US interest rates over the past decade establishes this correlation hypothesis.

If capital flows are not adversely affected (but for the year-end considerations) materially, the outlook need not be bearish for the rupee.

What is the correlation?

Leaving aside reports of further large foreign investments (not necessarily the portfolio variety) into the economy being announced, one is struck by the timing at which this higher US interest rates/lower capital flows to India theory is being put forward.

We have come through or, to be more realistic, we have possibly entered the last stage of this rate hike cycle in the US, with portfolio capital flows into the Indian markets at all-time highs. Between June 2004 and now, while the US rates have gone up by 275 basis points, capital flows to India have been $11-12 billion. This is an all-time high in capital flows for a period of slightly more than 12 months, ever since the Indian markets opened for portfolio investments in 1993.

The 275 bps rise in the US rates also represents the highest level of increases for any 12-month period in the past decade.

Going farther, an analysis of capital flows and US interest rates movements of the past decade also does not support this correlation theory. From the Table, the correlation between the two data sets is around 0.4 and it certainly is not negative. Even a cursory reading of the Table would show that there is no pattern or identifiable relationship between the two data sets. There have been periods when capital flows have fallen even as US rates either fell or remained stationary and also periods when capital flows have been strong despite elevated US rates. Thus, it is not surprising that moves in US interest rates explain only around 16 per cent (given a correlation of 0.4) of variation in capital flows into the country.

Therefore, even if the US rates move up further by another 100 bps or so in the next six months, one does not necessarily see an adverse impact on capital flows to the Indian markets. Historical correlations, either low or high, have, of course, broken down, if financial market history is any indication. Barring unforeseen developments or emergencies, therefore, higher US rates per se need not be that negative for the rupee.

Larger forces driving emerging market flows

The quantum of private capital flows which the Indian markets have received in the past few years is quite small in relation to the level of global private capital flows — running into hundreds of billions of dollars. It is doubtful if the relatively smaller level of capital flows has a clear defined relationship with the level of/movements in hard currency interest rates.

Such capital flows into emerging markets possibly represent another dimension of international portfolio diversification. And it is pertinent to note here that such portfolio diversification is driven by perceptions of a negative correlation between the home markets (of investors) and the emerging markets.

Even in a global economy integrating at a frenetic pace, there are differences in individual countries' growth patterns/cycles. The example of the British economy readily comes to mind. Here is an economy that has possibly had the longest stretch of uninterrupted expansion in the G7 grouping — even as other countries in the group, such as Germany and France, have had considerable fluctuations in the level of national output/GDP.

The UK economy, with its close linkages with the Euro zone/OECD grouping, has exhibited a longer economic cycle than that of its economic partners. If that is the case, one can be quite optimistic about the Indian economy's ability to provide the international investor that enhanced level of growth and help him reap the benefits of portfolio diversification.

The immediate future

The structural issues mentioned above notwithstanding, the focus is on the immediate future. There has been considerable volatility with the rupee falling around 3.5 per cent in the space of a couple of weeks. Could it fall further or have we formed a new base around 45.20 for some time to come?

A noticeable feature in the recent developments on dollar/rupee front is that the forward market has barely reacted. Even as the spot dollar broke fresh higher levels, the forward dollar continued to languish. Given the demand/supply-driven forward market in India, one would have expected the dollar's forward rates also to have firmed up in line with its spot rate. That has not happened.

Also, if the prevailing rupee bearish mood is expected to be sustained, one would have seen inter-bank positioning also pushing the dollar's forward rate up. That too has not happened. Is that a silver-lining for the rupee in the short term?

(The author is Associate Vice-President (Treasury), ING Vysya Bank Ltd. These are purely his personal views.)

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