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Monday, July 2, 2007

Leave the rupee to the market

Why the rupee surged in the past few months is very clear. India has been the recipient of high capital inflows, Foreign Direct as well as Institutional Investment .

However, what clearly stands out is the high External Commercial Borrowing (ECB) by Indian companies. ECBs have been on the rise recently as companies take advantage of the recent rule changes by the Reserve Bank of India permitting companies to raise more money abroad.

This works well for companies because they pay less interest compared to they would if they borrowed in rupees.

That said, while the general appreciation against the yen, the euro, and the pound can to an extent be explained by ECBs and FII/FDI flows, the situation against the dollar is a tad different.

The dollar has been on its own slump against most currencies because of recent issues with its economy, such as the general slowdown, the high interest rates, the problems in the sub-prime loan industry, and the high current account deficit.

However, one of the biggest reasons for the slump of the dollar is the bad news that is coming out the Asian countries especially those with large foreign exchange reserves, in particular, China.

This had the effect of keeping the value of the dollar high whilst keeping the interest rates low.

Now countries want to diversify their holdings of reserves and recently China said it wants to diversify the reserve holdings. Whether it will really diversify is not known but its mere mentioning of the fact had the effect of knocking the dollar fairly hard.

In theory, this deficit should have led to a fall in the dollar but it didn’t because the Asian countries hoarding reserves were doing so in dollars and this supported that currency’s price.

This huge deficit (most of it trade deficit) has increased the vulnerability of the dollar primarily because its future has become unpredictable.

The Effects of a Strong Rupee

The whole concept of outsourcing to India is the cost arbitrage that foreign companies get. The value of the contract will rise just because of the rupee appreciates and the Indian software companies have to take the hit for this rise.

Software companies have already given profit warnings post the steep appreciation of the rupee. On exports, it is going to have a fairly huge impact. Industries such as tea are already complaining about the effects that a strong rupee is having on tea exports. The REER of India against six countries as well as 36 countries (data for the first set are available until May 2007 and for the second until March 2007). show that with regard to the 36 countries the rupee is just overvalued, the six-country REER shows the rupee to be heavily overvalued. What this overvaluation means is that India has become uncompetitive and that goods from India are not price competitive vis-À-vis other countries.

When a currency appreciates, it more or less hits the trade balance.

India’s trade balance and the exchange rate on a monthly basis between January 2006 and April 2007 show that as the rupee appreciated, the trade deficit increased a month or so later. This lag is because foreign importers need time to react to the exchange rate. In April 2007 there has been a sharp rise in the trade deficit, a casualty of the exchange rate appreciation in March.

The Deficit Relation

With regard to the relationship between exchange rates and trade deficits, as the rupee weakened from 2000 to 2003, there was a general reduction in the trade deficit as a percentage of GDP. However, as the rupee strengthened, the trade deficits as a percentage of GDP start to get higher. 2007 is an anomaly but that was due to two reasons. One was high oil prices because of which the import bill was much higher than usual and the second was that production was at near full capacity and the only way to satisfy demand was to import.

Though much has been made in the media that a stronger rupee reduces the level of inflation since imported goods become cheaper, it is mostly a fallacy. This strong currency reducing inflation (also called ‘import led inflation’) works well in small open economies and India is neither. A strong rupee does initially have the effect of reducing the trade deficit but over a few months, exports usually get hit and imports boom because it is cheap to buy from abroad.

As this continues and the trade deficit gets higher, the rupee starts to depreciate because there is now increased demand for the foreign currency and it is back to Square One. Then what happens is that the weaker rupee will actually bring in inflation. Though the rupee is currently being supported on the back of very strong capital inflows, one must also note that most of those inflows are those that will also one day leave the country (ECBs and FII).

Where is the Rupee Headed?

However, any forecast of beyond a year should be taken with a grain of salt. A forecast of the rupee is something that falls into that category as there is no standard quantitative model to forecast the rupee movement and most forecasts of the rupee are qualitative judgments.

My view on the rupee is fairly similar to the above. In the near-term, it should be in the 41.50-42 range. The reason is that the rupee gets heavily influenced by FII inflows. FIIs (hedge funds) are bringing in big sums because of the property market and Initial Public Offers by Indian corporates as well as the booming stock market. However, most of this money is short-term and will go out of the country fairly soon especially as stock market and real-estate valuations in India are generally thought to be in the expensive and over-valued.

The rupee, in my view, will start appreciating again in around 18 months because FDI money into infrastructure projects will start coming in and this money is going to be fairly large. However, it is unlikely to appreciate beyond the Rs 38 levels because the RBI will still view rupee appreciation as something that will affect the economy as it can hit the software and the export sectors fairly heavily.

What the past few months have shown is that a currency that is managed just does not work in the long term. It gives the illusion of being a panacea but in effect only pushes problems into the future. The gist is that the rupee needs to be left to market forces. They may be some volatility in the beginning but then it usually will sort itself out.

The RBI may have been a decent manager of the currency before but that was when capital flows were at a minimum. It would be fair to say that central banks are often out of their depth in this era of modern capital flows.

The only way out of this predicament is to free the rupee and for the country to adapt itself to a free floating rupee as the costs of managing the rupee will soon outweigh any benefits.

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