We track the five fundamental drivers of the rupee and how they have been moving.

The rupee did a merry jig in 2012, causing a great deal of trouble to companies, regulators and investors. It appreciated to 48.6 against the dollar at the beginning of the year and then went on to its life-time low at 57.3 only to surge towards 51 again by October.

However, the trajectory of the rupee is downward against the dollar since July 2011 with the currency down 24 per cent since then.

The cause for this weakness appears mainly domestic because rupee weakness is not just limited to the exchange rate against the dollar.

The Indian currency is down 22 and 25 per cent against the Japanese yen and British pound, respectively, since July 2011. Even against the beleaguered euro, rupee has declined 12 per cent. The rupee also recorded its life-time low against all the above currencies in 2012.

Here are five fundamental drivers of the rupee and how they have been moving.

Dealing with deficits

The Indian economy has been sporting a current account deficit regularly since mid-2005 and this is one of the primary reasons the rupee has been on a secular downtrend.

This was considered acceptable, given the expansionary phase of the economy. But the slowdown in exports in recent times belies this argument.

Exports of goods that were growing around 40 per cent in recent years have decelerated since the last quarter of 2011. The monthly change fluctuated between -15 and 5 per cent between November 2011 and October 2012.

This has, in turn, impacted growth in merchandise imports too, with monthly average change at negative 2 per cent since this April against an average increase of 32 per cent in 2011.

Ongoing troubles in the Euro Zone have had a negative impact, with exports to this region recording a 15.8 per cent decline in the June 2012 quarter.

Exports to developing nations also declined. Higher contraction in imports has, however, helped reduce the trade deficit by 5 per cent in the June quarter compared with year ago quarter.

The current account deficit also reduced slightly in the June quarter helped by the lower trade deficit and higher remittances from overseas Indians. But sluggishness in services exports that grew at just 2 per cent in June quarter against 27 per cent growth a year ago is a point of concern.

The European Central Bank expects the Euro Zone economy to either shrink by 0.9 per cent or post feeble growth of 0.3 per cent in 2013.

With the IMF revising its April 2012 forecast for advanced economies down, from 2 to 1.5 per cent for 2013 and from 6 to 5.6 per cent for emerging economies, exports are not expected to pick up soon. But subdued commodity prices and crude remaining in a range between $80 and $110 can keep the current account deficit under check next calendar.

Flows to forge

Foreign direct investment inflows have not been strong this fiscal. Between April and September 2012, the country received $12.8 billion of inflows. This is down 44 per cent from the $22.4 billion received in the same period last fiscal year.

Policy paralysis and lack of clarity on taxing cross-border transactions took their toll on these flows. That said, FII flows have been robust in 2012 with almost $20 billion invested in equity and $6 billion in debt, according to the Securities and Exchange Board of India (SEBI).

This compares favourably with almost nil net inflows into equity and $5 billion in debt in calendar 2011.

Postponing of General Anti-Avoidance Rules (GAAR) has been received well by overseas investors.

Lack of alternate avenues for investment has also made many global funds revise their rating for India higher.

With the change in Finance Minister and the reform rush seen in October and November this year, FDI as well as FII flows could pick up in the months ahead.

Depleting reserves

Forex reserve balance has been depleting since the last quarter of 2011 as the trade balance turned negative. The reserves hit the peak at $320 billion last October and have been moving lower since then.

Towards the end of October 2012, forex reserves were down 7 per cent from this peak at $295 billion.

Import cover provided by forex reserves had declined to less than seven months by October this year. Proportion of forex reserves to external debt is also at the lowest since 2003-04 at 83 per cent.

Reduction in forex reserves limits the Central Bank’s ability to intervene in the foreign exchange market to control rupee volatility.

While the RBI sold $7.8 billion and $7.3 billion in forex market in December 2011 and January 2012 it could net-sell only $2 billion between April and September this year, reflecting the reduced ammunition available.

External debt

Towards the end of June 2012, external debt outstanding was $349 billion, of which external commercial borrowings accounted for $133 billion or 40 per cent and NRI deposits made up 17 per cent. Sovereign debt and short-term credit made up the rest.

The point of concern is that short-term debt based on time left for repayment accounted for 43 per cent of the total debt. Forex reserves cover on short-term debt is also low at 52 per cent.

If there is a sovereign default in the Euro Zone with a liquidity crunch akin to that witnessed in 2008, the rupee could come under considerable pressure as refinancing these debts with short-term maturities gets more difficult.

Another matter for concern is that trade related credit (up to one year) spiked 17 per cent towards end of June 2012 to $70 billion.

True value

High inflation is another negative for the currency as it erodes its intrinsic value. The wholesale price inflation, which captures price rise at producer level, is growing between 7.5 and 8 per cent since the beginning of this calendar.

Inflation at the consumer level, as captured by the CPI, is growing at 10 per cent.

With the RBI projecting headline inflation to remain at current levels till March 2013, this factor might not trouble the rupee too much in the months ahead.

So, is the rupee over or undervalued now? One way to arrive at this is to look at the Real Effective Exchange Rate calculated by the Reserve Bank of India.

REER is based on rupee exchange rate against a basket of currencies of India’s trading partners adjusted for inflation.

While the RBI publishes REER for 36 as well as 6 countries, it is the latter that is tracked closely by it.

The Central Bank was known to keep the 6 country REER close to 100 to maintain export competitiveness of the currency.

The 6-currency REER has depreciated only 9 per cent since July 2011, against 24 per cent decline in the USD-INR spot rate.

The Nominal Effective Exchange Rate (REER not adjusted for inflation) has declined 14 per cent in this period, indicating that domestic inflation of our trading partners kept rupee more competitive than the rupee exchange rate conveys.

Towards the end of October, 6-country REER was at 93, implying that the spot rate (53.8 then) was undervalued and there was room for the currency to appreciate above 53.8.

The Central Bank also has to reckon with a host of currency speculators in the foreign exchange market who can cause the rupee to swing away from its true value.

It is not just the domestic exchange traded currency futures but also the off-shore non-deliverable forwards market that provides an avenue for speculators to influence currency prices.

To sum up, slowdown in exports and increasing proportion of short-term debt could maintain pressure on rupee. But FDI and FII flows could be good with the government signalling its intent to push forward with economic reforms.

Though growing short-term external debt is a concern, Indian companies have not had too much trouble in refinancing this debt in calendar 2011.

Moderating inflation with lower commodity prices could keep the rupee competitive setting up the range between 50 and 58 over the next 12 months.


(This article was published on December 8, 2012)
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