Rise of the rupee Will it last?

The rupee is on a strengthening spree since the second week of May; moving from 60 to 58.5 against the dollar. The deluge of foreign money flowing into India before and after the announcement of the election results is the primary factor behind this rise. Both the Reserve Bank of India and the Finance Ministry will not be averse to foreign money coming into India. These flows can bolster our forex reserves and prevent a recurrence of the nightmarish phase that the rupee underwent in 2013.

But is the rupee now in a safe zone? We look at the many parameters that affect the rupee to arrive at a conclusion.

In recent times, most discussions on the rupee outlook have pivoted around the current account deficit (CAD). This is because the sharp downward spiral last year was triggered by the fear of CAD getting out of control. In the December quarter of 2012, the CAD hit a life-time high of $31.9 billion (6.5 per cent of GDP). Attempts to dismiss this number as an aberration failed when the CAD for June 2013 turned out to be alarmingly high; at $21.8 billion.

Gold imports It was the sharp spike in gold imports in recent years that caught the eye of the Government and the RBI. Gold imports were also the easiest to curtail, without too much pain to any segment of the economy.

Numbers do show that as Indians shifted their savings from financial to physical assets in the aftermath of the 2008 meltdown, gold imports spiked higher. Monthly average gold imports, which were at $1.1 billion in 2006, jumped to $4.4 billion in 2011 and remained at those elevated levels through 2012.

The raging bull market in global gold prices from 2001 to 2011 could also have contributed to this gold rush. The frenzy became intense in the first quarter of 2013 as correction in global gold prices sent Indians into a stampede to buy gold. The country imported a record $7.1 billion of gold in January 2013.

The RBI and the Finance Ministry decided to clamp down on gold imports through a variety of measures. Thanks to these measures, gold imports declined to $1.4 billion in 2014. CAD for the December 2013 quarter also declined to $4 billion.

With strong demand from gold jewellers, the RBI has now slightly relaxed the import curbs. But it is certain that the vigil on gold imports will not be dropped. Import duty remains at the elevated 10 per cent and if there is any sign of CAD increasing, the regulator now knows the formula for a quick-fix.

Export slowdown The other factor that affected the CAD last year was slowdown in exports. Software services exports, which were growing at a healthy yearly growth of over 30 per cent prior to 2008, dropped to lower single digits in 2013. The growth even dipped to less that 1 per cent in December 2012.

But there is hope of revival on this front. Nasscom, the software industry body, has given its most optimistic forecast for software exports in the last three years, for 2014-15, at 13 to 15 per cent. IT majors such as TCS, Infosys and HCL Tech have shown revenue growth far higher than the Nasscom projection in the last quarter of FY14, which leads to the expectation that CAD and the rupee will not suffer due to slowing software exports.

Merchandise exports too are showing signs of revival with growth of 7.5 per cent in December 2013, up from 3.9 per cent a year ago.

Indian exports will also benefit from the recovery in other regions of the world. The IMF’s optimistic projection of 2.8 per cent growth in 2014 and 3 per cent in 2015 for the US, up from 1.9 per cent in 2013, is good news for exporters. Similarly, the IMF has projected 1 and 1.4 per cent growth in 2014 and 2015 for the Euro area, up from 0.4 per cent contraction in 2013.

In the same vein, Chinese growth is projected to slow from 7.7 per cent in 2013 to 7.5 and 7.3 per cent in 2014 and 2015. But this slowdown is conducive to the Indian rupee since lack of demand from China reduces commodity prices, thus driving down our import bill.

With crude prices expected to remain in the $100 to $120 per barrel range (unless there is any political unrest), there isn’t a great threat of imports getting out of hand.

Capital flows The rupee’s sharp slide from the May 2013 level of 53 to the August 2013 low of 68.8 coincided with the US Federal Reserve Chairman’s announcement that the FED would be cutting down on its monthly bond purchases.

This caused large outflows out of bonds of all emerging markets, including India, as yields on US treasury bonds spiked higher.

Between the last week of May and the end of August last year, FIIs pulled out close to $10 billion out of debt. The pullout continued up to the end of the year with foreign investors pulling out another $3.2 billion.

Since the Federal Reserve has begun its taper of quantitative easing since January this year, without any undue impact on global liquidity, the fears of FIIs on the bonds front appear assuaged. They are now betting on decline in policy rates pushing bond prices higher.

FIIs have bought $5.8 billion in debt so far this year. A relatively stable or appreciating currency is also a draw to these investors and we could see flows into debt continuing in the next 12 months.

Foreign portfolio investors in equity appear to be another class altogether. These investors appear wedded to Indian equity, come rain or sunshine.

Even as equities alternated between steep slide or stagnation in 2012 and 2013, FIIs net purchased $24 billion worth of stocks in 2012 and another $20 billion in 2013. They have poured in $7.6 billion so far this calendar.

The view in the market is that foreign investors with short-term view have been active in the run-up to the election verdict. Once the new Government shows that it means business, the long-term investors such as pension funds, insurance companies, mutual funds and so on will start buying Indian stocks.

With the market veering towards the view that we have now begun a multi-year bull market, the rupee is expected to have the prop of FII flows into equity for some time now.

Foreign investors taking a long-term view of India and bringing money in through the foreign direct investment route too are a loyal bunch.

There has been no let-up in foreign direct investment (FDI) flows into India, despite the extreme volatility witnessed in the rupee in the last fiscal year. FDI flows for the period between April 2013 and February 2014 stood at $31.7 billion. This is just slightly below the average inflow of $36 billion into the country between 2006-07 and 2012-13.

This data points towards possibility of much greater FDI flows as the Modi Government — which is expected to reduce red tape and make the process of doing business in India much easier — takes over.

Forex reserves The depleting foreign exchange reserve towards the middle of last year was another factor that emboldened currency speculators. High current account deficit and the RBI selling dollars to shore up the rupee made forex reserves decline to $275 billion in August last year; down 14 per cent from the peak of $320 billion recorded in November 2011.

According to the RBI, the forex reserves towards the end of September 2013 were enough to cover only 6.6 months of imports.

The ratio of short-term debt to foreign exchange reserves, which was 33.1 per cent at end-March, 2013, increased to 34.2 per cent by September that year.

The situation is a lot more comfortable now. Forex reserves on May 9 stood at $313 billion, thanks to large FII flows and the RBI purchasing dollars.

This has made the import cover increase to almost nine months. While this is short of the 10-month import cover that is considered appropriate, it is far more comfortable than the situation last August.

The proportion of short-term debt to forex reserves is also slightly down to 34.1 per cent.

With the country set to receive sufficient portfolio and FDI flows for the rest of this fiscal, depletion in forex reserves is not likely. Further, the RBI is likely to continue to buy dollars to build reserves that can shield it against future volatility caused by global factors.

Speculative attacks Besides weak CAD, depleting reserves and humungous outflows, it was the action of speculators between June and August last year that exaggerated the down-move in the rupee.

The strong linkages between the three rupee markets — the inter-bank market, the exchange-traded futures market and the offshore non-deliverable forward (NDF) market — made banks and other traders play on the price differences between these markets.

Price transmission between these three markets also resulted in speculators influencing rupee movement through their trades in the NDF market.

Such an attack is not likely to be repeated for various reasons. One, the RBI has imposed curbs on banks based out of India trading in exchange-traded currency market as well as NDF market. This has effectively plugged the arbitrage trades between the three markets. The relatively comfortable CAD and forex reserves place the country in a stronger position, making it less vulnerable to speculative attacks.

Global environment This is the joker in the pack. While the conditions within the country can be understood to a fair degree and built into currency forecast, predicting the moves of the various global central bankers, including the US Federal Reserve, European Central Bank, Bank of Japan and the people’s bank of China is a more difficult task.

Then there is the fear of political unrest on the lines of the Russia-Crimea stand-off or the recent Thailand coup. Such events can send risk aversion soaring and cause money to move out of emerging markets, back into home countries, causing volatility in currency.

The other big risk to the rupee is from the US federal fund rate moving higher from the current near-zero level.

Once this happens, those investors who have borrowed in dollars to finance their global investments will sell assets all over the world to repay their dollar loans, which would have turned more expensive. This can usher in another bout of turbulence.

To sum up, the balance of payments has improved considerably, but our dependence on foreign portfolio flows to bridge the gap in current account keeps us vulnerable.

The threat to the rupee from external factors such as policies of global central banks and geo-political risks also continues to exist. So, while there is no threat of the rupee going into a steep slide akin to 2013, the rally in the rupee is also likely to be capped, a little above current levels.

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