The rupee’s 1.9 per cent free-fall against the dollar on Monday has taken forex-market watchers by surprise.
Not much has changed for the rupee’s fundamentals overnight. Widening current account deficit, driven by surging gold imports and slowing exports, and fears of foreign portfolio flows depleting on global central banks reducing their quantitative easing programmes have been weighing on the Indian currency over the past two months.
FIIs pull out
Monday’s decline seems triggered by data showing that foreign institutional investors have pulled out $1.3 billion out of debt assets in the first week of June. The breach of its previous life-time low at 57.32 recorded on June 22, 2012, could have triggered trading stop losses exacerbating the rupee’s fall. Many fresh short positions would have also been opened by currency traders causing the downward spiral in the Indian currency.
Besides the inter-bank market and the exchange traded currency derivative market for the rupee, there also exists an offshore non-deliverable forwards market where hedge funds and other speculators take a call on the rupee’s movement. The RBI has little control over these traders. According to Bloomberg, 1-month dollar rupee forwards in this market were trading at 58.4 while three month forwards were at 59. Volatility aside, what is the underlying value of the rupee?
Underlying value
One way to gauge the fundamental value of the currency is with the aid of the Real Effective Exchange Rate (REER). This rate is the rupee exchange adjusted for the relative differences in inflation with its trading partners. When this rate is at 100, the rupee is said to be rightly valued.
While the RBI publishes REER for 36 as well as six countries, it is the latter that is tracked closely by it. The central bank was known to keep the six country REER close to 100 to maintain export competitiveness of the currency. The six-currency in this basket belong to the US, the Euro Zone, UK, Japan, China and Hong Kong.
The latest figures show that the six country real effective exchange rate was at 106.3 towards the end of April this year. This meant that the rupee was overvalued by 6 per cent at that point.
The rupee has depreciated 7.8 per cent since then erasing this overvaluation. Since inflation based on the wholesale price index has declined from 7.28 per cent to 4.89 per cent by end of April, the rupee could now have moved in to under-valued zone, according to this metric.
In other words, there could be some room for the rupee to appreciate from Monday’s low. Any further fall will take the currency deeper in to the undervalued zone.
The REER was the most overvalued in July 2011 when this index was at 117.7. It may be recalled that the rupee was at 43.8 against the dollar at this point.