Most factors point to further decline in rupee
The RBI is obviously not run by former alumnus
In late-March, this writer has done a back of the envelope calculation of divergent US and Indian interest rates and their consequences in a rediff column (The strange case of the rupee: March 25-27). A look at the possible free arbitrage positions on 3-month rates had then suggested that the rupee would slide to around Rs 44.85 with a late June-early July perspective.
Dr Jalan has access to far more in the way of trade-data and corporate dollar demand. He is thus capable of running far more sophisticated models and the RBI can calculate likely exchange levels with more accuracy than any outsider. But the underlying logic and the basic trend would remain the same.
Briefly, the Indian government has tried to bring down interest rates to facilitate a borrowing programme on the order of Rs 1.17 trillion this fiscal. Meanwhile, the US Federal Reserve has raised interest rates through the last 18 months in an attempt to stop American over-heating. The Fed has only stopped hiking very recently. The divergence in trends forced the rupee down.
In late-March 2000, the rupee was held at Rs 43.60/$. This was with an annualised nominal 3-month interest rate of 9.12 per cent and a Wholesale Price Index (WPI) inflation rate of around 5.9 per cent. The US dollar was fetching a yield of 6.05 per cent at the 3-month annualised rate with 3.6 per cent inflation according to the US Consumer Price Index (CPI).
Ignoring inflation for the moment, run through the arbitrage scenarios. A banker converts rupees into dollars, takes the US interest rate yield and comes back into rupees. He can also convert dollars to rupees, take the rupee interest rate and re-convert to dollars. The two returns must be equivalent. To maintain that parity, the rupee had to drop since the US return was higher.
Now let's look at the inflation scenario. Since March, Indian inflation has increased. The WPI has climbed from 3.5 per cent in March to 5.9 per cent in July. It is true that point-to-point calculations of inflation are notoriously difficult to convert into an average rate. But whatever measure of Indian inflation is employed, the trend is rising. So the real return on Indian debt has declined.
Meanwhile, US inflation has increased marginally to 3.7 per cent but the interest rate has also been hiked from 6.05 per cent to 6.53 per cent. The US uses far more sophisticated inflation measures. The benchmark is the CPI rather than the WPI and something called "Headline inflation", which is a calculation of producer prices stripped of energy and food components. Direct comparison of US inflation with India and, hence, real returns on debt is impossible. But return on US debt is higher than in March 2000.
Adjusting for this trend of further divergence, the pressure on the rupee has to be even greater. Right now, the Indian 3-month rate is at 9.15 per cent annualised, with the US rate being at 6.53 per cent. At a conversion rate of Rs 44.90, the exchange rate should fall to around Rs 45.19 in the next 3 months, by the basic arbitrage equation. The 3-month forward premium doesn't reflect that at the current level of Rs 45.06, so be prepared.
Other macro factors all look even more skewed in favour of a rupee decline. High crude prices have contributed to a gradual erosion of forex reserves and the RBI has accelerated the process by chucking $ 2 billion down the drain trying to "protect" the rupee.
Further pressure has come from the net negative stance of the FIIs in the last couple of months. Portfolio investors have pulled out around Rs 15 billion this month and Rs 5.87 billion in June.
On the external front, a slide in rupee values won't really make too much of a difference and may even do some good. Export growth rates have been good and so have Invisibles, which include IT exports at around an estimated $5.7 billion. A drop in rupee values will boost these returns.
Reserves at $33.8 billion plus have declined but are still held at comfortable levels. Exporters certainly won't mind a decline and neither will "Bombay Club" members, who are running scared at the thought of external competition. We can live with a weaker rupee.
The rupee is, in fact correcting back to a long-term trend. Between January 1992, when it was trading at Rs 25.95/$, and January 1999, it declined by around 7.7 per cent per annum compounded. But between March 1999 and March 2000, the rupee only lost 2.5 per cent in nominal terms. That was due to an abnormal slowdown in inflation coupled to lower credit needs during a recession. In the last four months, the rupee has lost around 3 per cent, which annualises back closer to the long-term rate.
The domestic impact of a rupee decline will actually be more severe than the external fallout. The latest hike of the Bank rate and the CRR is part of the RBI's defensive measures. This will translate into a higher interest rates. An important signal was the recent 98 per cent devolution of Rs 40-billion RBI auction. There are no bidders at current yields so the yields must rise.
Rising interest rates in the 'Busy Season' won't be good for economic recovery, but there seems to be little room for manoeuvre. Couple higher inflation to the need for Rs 45 billion in market borrowing per fortnight and a rate hike is forced.
The RBI has only completed 43 per cent of its annual borrowing programme in the first quarter. Usually the central bank tries to finish at least 55 per cent in Q1 to avoid crowding out commercial borrowings in the Busy Season.
Now crowding out looks inevitable. The pressure will be increased by a likely liquidity mismatch in the second-half money market. On a gross level, the government needs to borrow Rs 1.17 trillion as per budgetary estimates. Inflows from redemptions of outstanding securities (Rs 400 billion) and interest on market loans (Rs 440 billion) totals around Rs 840 billion. So there is a liquidity shortage of about Rs 320 billion. However Rs 500 billion of those Rs 840 billion inflows come in the first half. So the liquidity mismatch will be marked.
The pressures could be eased by either monetisation, or a drop in government borrowing requirements. Monetisation has increased. Net RBI advances to Centre are around Rs 210 billion, which is twice last year's levels of Rs 103 billion. The only other option is to reduce government borrowing requirements with a few big-ticket disinvestments. A shortfall of Rs 300 billion could easily be met if Department of Telecom Services or a oil-PSU or three oil-PSUs were sold off. Otherwise get set for a slow Busy Season where corporates are starved of cheap capital.