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March 29, 2000

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The strange case of the rupee

Devangshu Datta

A famous Sherlock Holmes short story features a dog that does not bark at night despite the occurrence of several strange incidents. Last year, the rupee behaved just like that apocryphal dog. Kargil happened, the euro was launched and saw a steady decline, the yen did its own thing and rose despite a continuing Japanese recession and zero-interest rates. Partially, because of the 50-day war, India also ran a huge fiscal deficit. But the rupee did nothing and thereby surprised everyone except perhaps, the Reserve Bank of India (RBI) governor, Bimal Jalan.

In March 1999, the rupee was trading at Rs 42.45. By September, it had eased to Rs 43.53. By December, it was still in the same range and wonder of wonders, as March 2000 enters its last week; the rupee still sits at Rs 43.60. That just means a nominal decline of 2.5 per cent year-on-year. Meantime, the euro has dropped from $1.05 to $0.92 and the yen has risen from 118 to 107 per greenback.

Now, the rupee's behaviour is abnormal by its own historical standards. Since January 1992, when it was trading at Rs 25.95 a dollar to January 1999, it declined by around 7.7 per cent per annum. Pokhran II knocked several spots off it. So, Kargil could have done far more damage and at the least, caused greater volatility.

The Indian currency is only partially protected. No one sets the exchange rate. A foreigner can bring foreign exchange in and take it out with no hassles. An exporter can retain currency abroad and importers can cheerfully convert rupees to buy abroad. Even a business traveller has easy access to forex. The only restriction is on the common private citizen. He can't walk into a bank and convert holdings into hard currencies. The insulation would not, in itself, have been sufficient to keep the rupee flying.

Part of the reason for the rupee stability was the unabated confidence on the part of portfolio investors. Last financial year, they brought in more money than ever before. As a result, the RBI is now sitting on $ 32.7 billion of reserves. Another reason was that domestic interest rates remained very high. In a year when inflation declined to 2.5-3 per cent levels, the real interest rate stayed above 8 per cent.

Exports were reasonably strong showing a growth rate of 12.9 per cent until January. Imports didn't grow at the same pace, excepting for petroleum, of course. Crude price rises caused a big negative trade balance.

Strong "Invisibles", namely software sales of around $3.5 billion in the first three quarters, continued to partly compensate. So the current account stayed in control at minus $4.4 billion.

Is fiscal 2000-01 going to see the same stability for the Indian currency? Well, let us hope it doesn't happen at the cost of high real interest rates and slow imports. The first one would cut off a cheap economic recovery and a lack of import demand would also suggest a slowdown.

There is an ongoing attempt to bring down the real interest rate. By cutting the politically intractable provident fund rate, the government has sent a clear signal. Bimal Jalan has also done his bit to talk the market down and he could well cut the influential bank rate fairly soon.

But the government has also charted a huge borrowing programme of around Rs 5,000 crore ($1.1 billion plus) every fortnight in this fiscal. So this will probably keep market rates high. We could expect real interest rates of 6-7 per cent this year if one assumes an inflation rate of around 5 per cent. This is unfortunate for the economy as it could do with cheaper money. However alternate funds could be sourced from listings on NASDAQ, GDRs and private equity/venture capital flows for the infotech industry at least.

Imports would rise quicker this year only if the economy continues to expand. This would be desirable because, contrary to the swadeshi/ left-wing perception, most Indian imports tend to be of important capital goods. You certainly cannot improve infrastructure, for instance, without quickening imports. Petroleum import pressures could ease if crude prices continue a very recently noticed southward trend.

It isn't particularly desirable that the rupee remains rock-stable. Exporters will lose competitiveness versus the fast-recovering economies of East Asia if the rupee doesn't ease off. Most analysts are hoping for Rs 45-46 a dollar by the end of this fiscal and exporters would certainly be happier at those levels. I don't think too many domestic businessmen would mind a decline either. It would enhance protection against imports.

In fact, a correction in the rupee looks quite likely in the near future. As one mentioned earlier, dollar interest rates are hardening, while rupee interest rates are dropping albeit not as quickly as desired. Other things being equal, this must mean a falling rupee.

To be precise, the current annualised 90-day US rate is 6.05 per cent (up from 4.8 per cent a year earlier). The annualised Indian 3-month rate is 9.12 per cent. To ensure equivalent returns in the future, the current rate of Rs 43.6 a dollar should drop to around Rs 44.85. That's a ballpark estimate; if the divergent trends in US-Indian rates continue, the rupee must drop even further.

In practice, the RBI can certainly influence the rate of decline or even arrest it by selling dollars. Presumably, the central bank will do its best to ensure that the drop isn't violent and precipitous, but all the indications are that the RBI would like the rupee to smoothly move down. Forward forex premium rates are still rather higher than the above back-of-the-envelope calculations would suggest.

In broader macroeconomic terms, one would have expected the serious fiscal slippage in the last year to have exerted even more downward pressure on the rupee. But given the Moody's outlook upgrade and the fact that FIIs are still net positive, it doesn't seem to have altered perceptions that much.

A controlled landing in the rupee, should have a positive impact on the exporter. One interesting thought - is the tax on 20 per cent of export income going to be rupee-denominated? If so, it will cancel out some gains in bottom lines though the greater competitiveness of a lower rupee will still help export volumes.

As exporters go, the high-fliers are mostly in the infotech and pharma industries. The latter industry could certainly do with a boost since it has been hit hard by this Budget. Another depressed industry that could benefit is tourism. The hotel business has suffered through the recession. Occupancy rates dropped as business travel declined. But it has strong forex earnings and an ongoing economic recovery combined with the Clinton visit could bring high-end visitors into India along with the feel-good factor. Another interesting single-company bet is ITC - it's amongst the largest exporters.

Devangshu Datta

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