Rupee hits all time low driven by strong market forces in favour of the US Dollar
The rupee is weak since July 2011 based on weak macroeconomic fundamentals driven by low growth; high inflation; tight liquidity; high interest rates; high fiscal deficit and high trade deficit. The system is in the wrong side across all parameters. The sentiment into the future is also negative taking into account the ability to address these structural issues and constraints in attracting long term capital flows through policy reforms. The combination of weak fundamentals and negative sentiment has squeezed the Balance of Payment position, thus setting up the bearish trend for rupee. The quality of inflows is also in doubt as large component is from hot money FII flows and short term debt obligations. All these factors have been more or less captured in sharp rupee depreciation from 43.85 to 54.30 since July 2011 where rupee is seen to be highly undervalued. Then, why is this run on the rupee? The market forces have turned strongly in favour of the US Dollar (against major currencies); global investors are in risk-off mode resulting in sharp fall in hot money FII flows and combination of weak macro fundamentals, negative sentiment and bullish USD (and weak Euro) has caused demand over-run in the forward market in anticipation of more rupee weakness ahead. The only positive cue is from sharp fall in BRENT Crude by 13% but not seen good enough to counter negative forces in play.
Rupee stability is dependent on two main factors: regular net inflows through Capital account (whether hot or cold) and net supplies from forward market into spot market. The aggregate of both should be adequate to cover deficit in trade/current account. The other important factor that provides two-way volatility is the market behaviour of the US Dollar against major currencies reflected from movements in USD Index and/or EUR/USD. What is the outlook? There is no chance of overnight miracle to set right the fundamental issues on hand. These are seen as structural issues so as policy reforms; thus economic and political structures are weak, thus diluting the optimism into the future eroding the investor and business confidence. As long as these two structural issues are valid, it would need weak dollar (strong Euro) to get the forward market into supply driven mode. Exporters should get the confidence that there is no risk of rupee depreciation beyond what they get as premium. This confidence may not be there when dollar is extremely strong driven by all sorts of woes from the Euro zone; thus forward market may not get into supply driven mode till USD loses steam against Euro. The demand pressure on spot market on front-load of 3-6 month imports is enough to push rupee down and it would be worse if exporters are either already covered or refrain from hedging future receivables. RBI did its best to provide support but was not good enough to counter Tsunami like headwinds from all sides. RBI has not enough dollar assets to absorb the huge dollar demand over supplies or enough surplus rupees in the system to allow shift of dollar assets to rupees in RBI’s balance sheet. Given these structural issues (with no concrete solutions with the Government or RBI), rupee will be under tremendous pressure if market forces signal strong US Dollar. USD Index is up sharply from 78.50 to over 81.50 and looks good for further extension over 82.50 into 85.00 on strong downward pressure in EUR/USD below 1.25 into 1.18. It is also possible that moves in USD/INR will have excessive traction with USD strength and marginal benefit to rupee on recovery in EUR/USD. The domestic stock market is also weak with immediate objective for NIFTY at 4500 and FIIs are not seen to provide temporary relief by pushing in hot money flows. The risk of reverse flow of FII money is not ruled out. Therefore, taking all these together, outlook for rupee is for gradual weakness to 55.35-55.65 not ruling out extended run into 56.30-56.75 before sharp reversal into 52-51. It is important that Government work towards addressing structural issues relating to political and economic environment to get the confidence back into optimism. This will enable RBI to shift into aggressive growth supportive monetary stance for bullish outlook on the economy and its markets. It is possible that RBI will allow rupee to find its own floor and limit its intervention operation to halt excessive one-way volatility.
Moses Harding
Head – ALCO and Economic & Market Research
IndusInd Bank, Mumbai
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