Talking Point. Why rupee should strengthen further

The rupee’s recent strength against the US dollar has taken most forex analysts by surprise. Even as bets were increasing about the rupee sliding to 70 towards the beginning of this calendar, the currency did a volte face and has strengthened 6 per cent against the greenback.

While various reasons are cited for the currency’s strength, including copious foreign inflows, the movement of the dollar appears to be the most important factor affecting the movement of the Indian currency. The dollar’s prospects, in turn, appear hinged on the growth in the world economy, going by empirical evidence.

If we consider the movement of the rupee-dollar exchange rate over the last two decades, periods of strength in the rupee have coincided with strong economic growth in India.

Take, for instance, the period from June 2002 to December 2007, this was a golden period for Indian economic growth with GDP growth improving from 3.8 to 9.8 per cent. The rupee appreciated 20 per cent in this period.

Similarly, from the first quarter of 2009 to mid-2011, the rupee gained 15 per cent even as economic growth improved from less than 5 per cent to double-digit growth.

On the other hand, periods of rupee depreciation, in the last 20 years have been accompanied by flat growth. For instance, between mid-11 and 2013, the rupee fell from 43 to 69 against the dollar but GDP growth remained around 6 per cent in this period. The only exception was in 2008, when there was a sharp contraction in growth along with steep rupee depreciation.

In short, while periods of strong economic growth coincide with stronger rupee, rupee depreciation is not always linked to the economy.

Ultimately, since the value of the rupee against the dollar is the most closely tracked exchange rate, the movement of the dollar is the key to determining the moves in the rupee.

The dollar index, which tracks the movement of the dollar against five major currencies, has declined sharply since the beginning of this calendar, down from 102 to 93; loss of 9 per cent. The dollar weakness has led to strength in not just the rupee but in other emerging market currencies as well.

The inference is that it is important to understand the direction in which the dollar is moving in order to guess the rupee’s trajectory. The dollar index has raced higher since mid-2014 when talks of US Federal Reserve hiking rates and beginning monetary policy normalisation began doing the rounds. From 78 in 2014, the index hit the recent high of 103 in January this year.

But there are reasons why the reversal since 2014 might have ended in January. The rally was led by the relatively hawkish stance of the US Federal Reserve even as other central banks such as the European Central Bank continued with their monetary easing.

But there is a view that the dollar has already priced in future hikes and monetary tightening. Two, Trump failing to deliver on his promises so far has been another reason why dollar has been giving up its strength.

Besides the above reasons, stability in global growth could be another reason why dollar is sliding. Dollar index has been weaker in periods when global economy was in an expansion phase and stronger when growth slumped. This could be due to the dollar’s status as a safe haven currency, with demand soaring in periods of economic crises.

Take, for instance, the period between 1971 and 1980. Global growth increased from 9.9 per cent to 12.6 per cent in this period. The dollar index, however, slid incessantly from 120 to 85 in this period. From 1981 to 1985, as global growth slid due to Iraq war and the crude oil price surge, dollar index rallied from 90 to 149.

Similarly, between 2001 and 2007, as global GDP growth recovered after the World Trade Centre bombing to increase from -0.6 to 12.6 per cent, dollar index declined from 119 to 76.

The converse is true when global growth is weak, dollar tends to rally. The period between 2010 and 2015 has seen global growth slip from 9.7 to -5.5 per cent. That’s the period when the dollar index recovered from its structural down-trend from 78 to 98.

It is obvious that the dollar’s movement is hinging on global growth outlook and the rupee is linked to dollar. Global growth has stabilised in 2016 after the commodity slump and crude oil price decline witnessed in 2015.

Despite major events such as Brexit and Trump’s election as POTUS, global growth has improved to 1.5 per cent in 2016.

The IMF expects growth to be better in 2017 and 2018 due to “buoyant financial markets and a long-awaited cyclical recovery in manufacturing and trade under way.” The Euro Zone is witnessing stability and improvement in growth, and the US economy has been chugging along as well. Unless geopolitical tensions roil the picture, global growth could continue to inch higher.

Also, with other central banks too moving towards monetary tightening, the advantage enjoyed by the dollar is expected to wane, leading to the dollar index moving lower towards the 80 zone again. This creates the platform for the rupee to continue its strengthening and gradually moving towards the 58-59 zone against the dollar.