How high will the rupee rise?

DHARMAKIRTI JOSHI,
CHIEF ECONOMIST, CRISIL

Rupee could strengthen to 43.5 by March 2011

With the gradually easing capital controls, the value of the rupee is increasingly being determined by market forces—appreciating when capital inflows rise, and depreciating when foreign capital retracts. The opening up of the Indian economy, its improved fundamentals and rising foreign inflows have helped the currency gain strength in the last couple of years. The currency movements in the last few years also indicate that the RBI's ability to intervene in the foreign exchange market is now limited to curbing volatility.

The International Monetary Fund (IMF) has recently scaled up its global GDP growth projections for 2010 to 4.25 per cent from its previous estimate of 3.9 per cent. The improved global growth prospects imply more inflows into India and pressure on the rupee to appreciate. By the end 2010-11, I expect the rupee to strengthen to 43.5 against the dollar with bouts of volatility in between.

The exchange rate, being an asset price, is volatile by nature. Towards the end of 2008, as the global economic crisis intensified, rupee volatility increased and the trend of appreciation—which had started since 2003—also temporarily reversed.

In 2008-09, the rupee fell sharply against the US dollar (27 per cent) and the yen (32 per cent), but somewhat moderately against the euro (eight per cent). This was largely due to capital outflows resulting from the financial crisis. The British pound was the only major currency against which the rupee appreciated.

This was due to the weakness of the pound, which depreciated at its fastest rate ever against the USD. In 2009-10, the rupee appreciated against all major currencies— 10.3 per cent against the USD, 9.5 per cent against the euro, 7.2 per cent against the pound sterling, and five per cent against the yen. This rise in value was driven by resilience of the Indian economy and the return of risk appetite among foreign investors.

In future, strong growth in India and the accompanying capital inflows will continue to put upward pressure on the rupee. The value of the rupee will, however, remain susceptible to changes in global risk aversion and its impact on capital inflows into India. This was recently demonstrated by the Greek crisis, which brought down the risk appetite of foreign investors and weakened the rupee. The rupee has been volatile since then, and given the global economic uncertainties, this volatility is likely to continue.

A strong rupee has different impact on different stakeholders. It benefits importers and companies that borrow abroad. But it spells bad news for exports and the information technolgy (IT) and IT-enabled services sector. Among exporters, those with high import intensity are not affected significantly, as the fall in cost of imports offsets the negative impact of the appreciating currency.

Trends in exports, global growth and currency values suggest that global demand has a greater impact on exports than currency value. Further, one should not look at the rupee-dollar exchange rate alone.

Between 2003-04 and 2007-08, Indian exports grew 26 per cent a year despite the appreciation of 12.5 per cent against the dollar. The rupee, however, depreciated against the pound and euro by four per cent and six per cent, respectively, which partially offset the negative impact of appreciation against the dollar. This year, I expect the RBI to adopt a tolerant attitude towards gradual rupee appreciation, as it would complement its inflation control measures by making imports cheaper.

HEMANT MISHR,
MD & HEAD OF GLOBAL MARKETS, SOUTH ASIA, STANDARD CHARTERED BANK

Dip now, appreciation by year-end

The European crisis and contagion concerns over the PIIGS economies (Portugal, Ireland, Italy, Greece and Spain) continues to hog headlines and market activity. Pre-Lehman collapse, these economies were growth spots and investors were more than happy refinancing these countries' high debt levels. The world, however, is a very different place today and investors are moving out of emerging markets assets as appetite pole vaulted from risk seeking to risk aversion. As against a mad chase of yield, which was the theme until the crisis hit the market, for now Cash is King.

What does this mean for India and, more specifically, for the rupee? Doomsayers were quick to deliver the verdict—exaggerated global risks would sound the death knell for an appreciating rupee. Has the rupee taken a U-turn?

The rupee is clearly a higher-beta currency, i.e., it is highly correlated to the global economic cycle. Hence, it is susceptible to periodic corrections, especially in the current environment. Since its March 2009 peak, the rupee has suffered several instances of temporary losses on global uncertainties.

This episode represents another such pullback in the broad rupee rally and may continue as the markets assess the efficacy of the fiscal stabilisation fund of nearly US $1-trillion created for the euro zone. While the risks emanating from the euro-area have masked Asia's resilience for now, once sentiment stabilises investors shall focus back on India's positive fundamentals. Price action over the past year clearly highlights the growing importance of local fundamentals in driving the rupee's trajectory. Gains in 2009 stalled after the positive election outcome, as a modest balance of payments surplus lowered the pressure on the currency.

Momentum picked up only in the beginning of this year, after portfolio inflows surged back on an improved fiscal outlook post-Budget 2010. Given the positive economic outlook and a policy framework geared towards balancing growth and inflation risks, rupee gains are expected to sustain. Admittedly, the wide trade deficit is a cause of concern and portfolio inflows remain hostage to swings in global risk appetite. But pickup in debt-related inflows should provide relief, pushing the balance of payments towards a $40 billion surplus in FY11.

Also, one cannot rule out a signficant surge in portfolio inflows to India if the policy rhetoric remains favourable, as international investors may avoid the policy risk ridden West and scout for better alternatives. In addition, the yuan revaluation theme is also likely to continue exerting appreciation pressure on the rupee. Hence, exporters should use the down moves in the rupee as opportunities to increase their hedge ratios, not only against the US dollar but also other G5 currencies.

Continued appreciation may lead to some central bank intervention, especially with the real effective exchange rate above 113. But this is likely to be targeted at containing volatility, rather than stemming the rupee's tide. Burgeoning inflation risks and limited ability to sterilise suggest that aggressive intervention is unlikely. A move towards 43 by the end of this fiscal year is, thus, a plausible outcome.

However, this is contingent on the western economies' ability to avoid systemic risks. If the markets doubt the resolve of the western economies to manage these risks then the bout of risk aversion could continue for longer. Over the short term the rupee could slip to levels beyond 47 which are good levels for exporters to lock-in for mediumterm receivables given the high outright forward rates.