Rupee.....the spoilsport
It all began from the financial crisis in the Euro zone since July 2011. The financial crisis extended into monetary and economic crisis lead to sovereign rating downgrade with fear of sovereign default in most countries in the Euro zone. Since then, rupee is down from 43.85 to 53.88. The concern is the rate of depreciation at an alarming rate of 23% since August 2010. The primary cause for such a steep fall is not from domestic cues. The crisis in the Euro zone and the resultant shift of safe-haven to the US and the greenback drove the USD Index up from 73.50 to 80.50; down by just 9.5%. In the meanwhile EUR/USD was down from 1.4939 to 1.2964; down by 13.2%. The downward pressure on growth momentum pulled down all asset classes and money shifted into safe-haven sovereign bonds. The investor appetite was low given the risk of depreciation in the asset value with loss of time value on the investments. Cash and sovereign Fixed Income became the most preferred assets. These external woes caused sharp fall in domestic stock market with NIFTY down from 6338 to 4639 since August 2011; down by 26.8%. It is obvious that the worst losers are the rupee and domestic stock market. This brings the domestic factors into focus.
The huge dependence on external capital; liquidity and consumer demand was exposed. Exchange rate stability is dependent on adequate flows into capital account to bridge the deficit in the trade account. The dollar liquidity squeeze from the external sector widened the current account gap. The resultant shift of credit demand from foreign currency to rupees caused stress on the domestic rupee liquidity. The sharp fall in external demand for India’s goods and services exerted severe downward pressure on growth momentum. During this time, Indian economy shifted from high growth; high inflation to low growth; high inflation scenario. Over all, the fundamental issues of widening trading deficit; reduced capital flows and higher fiscal deficit pulled down the confidence on the domestic currency.
Another major concern is from the structural issue. The market was heavily one-sided till the Euro zone crisis. Market stake holders took comfort from the rupee stability to stay heavily short on dollars through uncovered imports; fully hedged exports; un-hedged short term carry trades from trade account and shift of medium/long term rupee liabilities to foreign currency for interest cost advantage without exchange rate cover. The forward market was also in supply driven mode tracking high forward premium of 6.5-7.0% on 12M tenor. It was not making sense then to pay 7% premium for 1Y dollar when rupee was expected to stay in consolidation mode around 44 with expectation of further appreciation into 39. The structural positioning of the stake holders were heavily one-sided unmindful of risk of sharp reversal. This is where the market was caught on the wrong foot. The market is now in demand driven mode with importers running for cover and exporters holding back their receivables; and it will be extremely difficult for RBI to reverse the trend with sporadic supply of dollars. At best, it could arrest the momentum to the fall with rupee bearish undertone firmly intact.
What next? The market should turn neutral to complement RBI’s intervention actions. RBI is short of dollars in its reserves and system is short of rupees to undertake aggressive dollar sales. The solution to this will be to “lead” export cover and “lag” dollar demand from importers. Exporters have already covered majority of their future receivables. This is evident from huge FX provisions in Q2 results. This will become worse in the Q3 results. On the other hand, uncovered imports (and the resultant loss) are not captured in the Balance Sheet. So, it would need strong reversal signal for importers to hold back their dollar purchases and exporters to sell balance uncovered receivables. The fundamental and structural issues discussed above will stay valid into the short term. Dollar will continue to be in its rally mode and it is important for EUR/USD to hold its weakness above 1.2850-1.3000. It is also important for domestic stock market to stay in stable mode to avoid trigger of FII exit. NIFTY has to hold its weakness above recent low of 4639. The outlook however is for extended gains in USD into 1.18 against Euro and NIFTY extending its weakness into 4250 driven by severe downward pressure on growth and rupee woes adding to inflationary pressure. The shift into low growth and high inflation economy will keep the equity market in bearish mode for extended period of time.
Over all, there is not a single positive factor at this stage for rupee to get back into its bull phase. It would need quick recovery in the external sector to redress domestic issues. Given the possibility of rupee getting into a 53-56 range in the near/short term; exporters may not enter in a hurry while importers run for cover to cut the loss in cost of import. RBI needs to think other than intervention to get the confidence back on rupee!
Moses Harding
Executive Vice President
IndusInd Bank
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