T. B. Kapali

A LITTLE more than a month after China revalued the yuan, the Indian rupee is again in the news.

This time, though, the rupee has fallen and the focus is on finding out if it will fall further.

There have been forecasts about the rupee weakening to the 45+ levels by next March. High and volatile oil prices and a rising trade deficit are seen pushing the rupee lower despite continued robust investment inflows (also current account inflows) into the economy.

The bearish rupee forecasts have also drawn support from the "over-valuation" in the inflation-adjusted effective exchange rate of the rupee. The over-valuation is seen getting corrected through a fall in the nominal exchange rate of the rupee.

This piece, though, takes the stance that in the current overall economic environment, a fall of the magnitude of 2-3 per cent in the rupee is not on the cards.

At worst, the rupee may remain range-bound around its current levels 44/44.20.

An overshoot of these levels is also possible given the interplay of technical adjustments in the market relating to immediate dollar settlements. The best scenario is for the rupee to go back right up to the 43.40/.50 levels.

Will a rupee fall help in this situation?

A perusal of market opinion makes it clear that oil is the proximate cause for the bearish rupee forecasts.

Not only is high priced oil causing the trade deficit to widen, it is also pushing up the real effective exchange rate (REER) through its effect on the inflation index.

Given oil's primary role in the recent weakening of the external trade account and the upward push it has given to price pressures, the question is, will a couple of percentage points fall in the rupee help mitigate the situation?

That is, will a 2-3 per cent fall in the rupee to, say, 45+, help improve the trade account (at least, reduce the deficit) and will it also cap inflation around 5 per cent?

The answer to both is no. And if the answer is no, it is difficult to see the Reserve Bank of India countenancing a fall of 2-3 per cent in the rupee in the ensuing period.

Why a rupee fall will not help?

Indeed, any sharp fall in the rupee in the current economic circumstances may further strain the oil companies' finances (and the Central Budget, in turn) and worsen the inflation picture. The trade deficit (in dollar terms) may not be any the better too. For any big down-move in the rupee may not significantly impact the overall demand position in the economy. It is pertinent to remember that it is surging aggregate demand in the economy that is widening the trade gap and bringing in the inflation pressures.

As long as there is not a full pass-through of international oil prices to the domestic consumption sector, there will be no perceptible dent on overall (oil) demand. What does it matter to the local consumer be it industry or the retail segment if oil is at $70 or even $100, and if the rupee is at 45 or 48 against the dollar, but domestic consumption is still possible at prices which do not allow effective operation of the principle of "price elasticity of demand"?

Full pass-through of international prices

The RBI has not stated the above explicitly in its recent annual report. But it is probably the above formulation the central bank has in mind when it argues in its report for a complete pass-through of international oil prices on to the domestic economy. The demand impact of any full pass-through may indeed be wrenching in the initial stages. But the really interesting point here is the central bank's readiness to face any demand cut-back and slowing down of economic activity consequent to a sharp rise in domestic energy prices.

The official recommendation from the central bank on oil pricing policy does point to the possibilities in India's emerging market environment.

For one, a sharp rise in local energy prices may possibly be countered with more flexibility for the rupee's exchange rate on its upside.

Indeed, the rupee's exchange rate could appreciate to dampen the inevitable pick-up in inflation brought on by higher domestic oil prices (to the extent such inflation pressures are not moderated by weaker demand). Not only that, the central bank could also possibly gain more flexibility on the interest rate front. Indeed, it is possible that the full power of the central bank's interest rate weapon to cushion a demand slowdown is realised in such a scenario.

Rupee outlook

On an overall reckoning, it is difficult to envisage a sharp rupee fall when there is little flexibility for the RBI in managing oil-induced inflation pressures and trade deficits.

Going beyond the immediate, there is another recommendation in the RBI's Annual Report which seems to be a vote of confidence in the rupee's ability to hold its own in a more liberalised trading environment. The suggestion to slash import tariffs across the board to a uniform 10 per cent is another pointer to the economy's ability to run higher trade deficits. The RBI says that in the prevailing environment, this would be a move with little or no downside risks. Given that, it is debatable if rising trade deficits per se would be as rupee-bearish as some studies point out they could be.

The recent fall in the rupee to the 44+ levels from 43.50 a couple of weeks back appears to have been caused partly on account of technical factors, such as the scarcity of dollars for immediate settlement and maturity mismatches in dollar flows in the inter-bank market. It has, however, given occasion for a look at the currency's prospects for the medium term. And these appear quite sanguine as of now.

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

(This article was published in the Business Line print edition dated September 5, 2005)
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