Special update on rupee

Rupee out of control....no quick fix solutions on hand

Rupee missed the all time low of 52.18 by a whisker but posted daily close above 52 for the first time; down by 19% since August 2011. The one-way run from 43.85 to above 52 is excessive. RBI’s efforts to cut the excessive one-way move have been futile. The unfortunate part is that there is not a single factor to bring the rupee bulls into street who was in total control till July 2011. There has been sudden reversal in rupee fundamentals driven by widening trade gap and reduced capital flows. The structural factors too turned against rupee through uncovered imports; un-hedged foreign currency carry-trade liabilities and shift of forward market into demand driven mode. RBI’s ability to intervene is also hampered by squeeze in system liquidity and limited dollar reserves in its balance sheet. The big blow came in the form of shift of economic woes from the West to the Emerging markets exerting downward pressure on growth momentum. The resultant run on equity market added to rupee woes. The hit on rupee is severe as most other peer group economies run trade surplus and stay less dependent on capital flows.

Currency depreciation is not a worry for economies running on low inflation engine and trade surplus. It is demonstrated that arresting currency appreciation is much easier compared to preventing run-away depreciation. We are now burdened with issues of high inflation and widening trade gap. Capital flows come in attracted by high growth and prudent fiscal management. The pressure on growth and slippage in fiscal deficit has cut the capital account flows. Moreover, the investor community from the Western economies is struggling for breath. All these issues cannot be addressed overnight; it takes a long time. While India is burdened with these fundamental issues, the structural issues are no better. The forward market has shifted from supply driven to demand driven mode; low premium is not good enough to sell dollars forward when rupee is down at alarming rate. Given the dollar liquidity squeeze in the system, FX forward premium will remain low to cover liquidity premium and higher credit spread. The shift of credit from foreign currency to rupee has added to squeeze of rupee liquidity. Both these factors would limit RBI’s ability to intervene both in the spot and forward market. Taking all these together, it is obvious that it is not going to be easy to defend rupee depreciation. It is a situation of getting caught between the devil and deep sea. There are lot of lessons to learn. It is important to maintain low inflation; high growth engine and run manageable trade deficit to avoid excessive dependence on off-shore liquidity. It is also important for companies to stop looking up to RBI intervention for their misdeeds.

What next? Rupee is now dependent on reversal in dollar strength against major currencies and release of bearish set up in the equity market. The sharp down move in EUR/USD from above 1.42 to below 1.35 and NIFTY move below 4850 are danger signals. It is important for EUR/USD to recover its strength above 1.40 and NIFTY above 5350 to provide reasonable correction in USD/INR into 51-50. The probability of this expectation becoming true is not high as downward pressure on EUR/USD and NIFTY is huge driven by Euro zone crisis with no signs of viable solutions to bring it back on its feet. It is possible that rupee has shifted to a higher base of 51 with next objective at 54-56. Definitely, this is not going to be liked by many (except those exporters who run uncovered receivables) but it is fact that rupee weakness would have been arrested at below 50 if there were options on hand to defend. So, we may need to be prepared for short term range play at 51-56. Aggressive intervention by RBI in the spot market will lead to higher call money rate and widening of arbitrage between off-shore NDF and on-shore OTC while selling in the forward market will push the forward premium down to widen the demand-supply gap in the forward market; thus exerting additional pressure on the cash market. The low FX premium will increase the cost of export credit as well. The only option is to open up the NRI gate by deregulation of FCNR/NRE interest rates. The release of dollar liquidity from NRIs will be positive for rupee. It may not be prudent for RBI to bring in restrictions on Forex operations to cut the dollar demand. Over all, there are no clear cut solutions to save rupee from distress and let us tighten our belts for hard landing!

Moses Harding