Near-term movements of INR will continue to be shaped by the capital flows situation, which in turn will be influenced by developments in Europe, writes Nischal Maheshwari.
The Indian rupee has seen a dramatic fall of over 20 per cent in the last 8-9 months against US dollar. While several other emerging market currencies have also been under pressure during this period, INR has been one of the worst performers in its peer group.
Such a sharp fall in a small span of time certainly creates challenges for the economy - domestic businesses that have foreign currency borrowing are hurt, foreign investors tend to stay away from the financial markets as INR fall aggravates their losses, domestic liquidity conditions worsen as RBI intervenes to check heightened volatility in INR and risk of imported inflation rises.
The key factor that is putting pressure on the currency is the stress in India's balance of payments (BoP), both on current account as well as capital account. India's current account deficit (CAD) has been on a widening trend over the last 4-5 quarters, breaching 4 per cent of GDP in December 2011, which is clearly a zone of high vulnerability.
Indeed, a cross-country comparison shows that over the last few quarters, it is the current account deficit countries that have faced the maximum stress, be it Indian Rupee, Turkish Lira, South African Rand or Brazilian Real.
High crude oil prices and rising gold and silver imports are the prime reasons for such a sharp widening in CAD. Notably, gold imports have reached 11.5 per cent of total imports in FY12 compared to 9 per cent in FY11, possibly reflecting higher demand of gold as a hedge against inflation and general expectations of rising gold prices.
Meanwhile, because of no pass through of higher international crude oil prices, domestic demand for energy remained buoyant, leading to higher energy imports. Indeed, looking at CAD from investment-savings balance, it is the dis-saving on the part of the government that led to lower national savings rate and hence higher CAD.
The stress on the BoP, however, has not been due to higher CAD alone. The capital account has been under pressure too. Barring FDI, flows in all other categories - portfolio flows, external commercial borrowings etc have been anemic.
For example, as risk escalated in Europe, EU banks retrenched their exposures to EMs including India, thereby pressuring currency. Indeed, in Q3FY12, capital inflows were insufficient to fund the CAD, leading to significant depletion in reserves.
So far, the RBI has taken several steps in order to check the sharp volatility in the INR, such as direct intervention in the FX market by selling USD, liberalizing the interest rate regime on the foreign currency deposits, putting limits on intra-day limits on positions taken by forex dealers etc.
While all these measures have been effective to some extent in curbing the fall in INR, they have not been able to decisively turn the market sentiments in favour of rupee.
Therefore, the question is what is needed to check the fall of INR. One is apparently, the stabilization in European situation. Currently, the odds are against it, at least in the near-term.
Inconclusive election results in Greece have triggered another bout of uncertainty in Europe. What happens in the fresh elections next month becomes quite crucial in that regard. In any case, these external factors are completely beyond the control of the Indian policymakers.
However, policymakers in India can surely attempt to reduce the CAD so that India's vulnerability to external shock is mitigated.
In this regard, passing-on higher energy prices on to the consumers is a crucial step. It will help reduce fiscal deficit (and hence improve government savings) and can also lead to downward adjustment in energy demand, once retail prices are hiked thereby reducing the energy imports.
Meanwhile, it is notable that after the fall of about 20 per cent over the last 7-8 months against USD, INR has become quite competitive on real effective exchange rate basis (REER).
For example, on 36 currency trade weighted REER basis, INR is now clearly undervalued. This will induce corrective bias in the CAD, by making the export-oriented and import-competing sectors more competitive. This augurs well for CAD in the coming year.
In nutshell, near-term movements of INR will continue to be shaped by the capital flows situation, which in turn will be influenced by developments in Europe.
However, at the domestic level, the government needs to urgently act towards reducing CAD by cutting down its fiscal deficit and improving India's overall investment climate so as to attract foreign capital flows.
These steps along with undervalued exchange rate could go a long way in stabilising India's BoP situation over the medium term.
Image: Nischal Maheshwari
The author is co-head Institutional Equities and Head-Research, Edelweiss Financial Services
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