29 March 2017 09:24:52 IST

Explaining the sharp rise in the rupee

While other currencies have appreciated, the decline in India’s inflation has been more than that of its competitors

Since the beginning of this year, the rupee has appreciated nearly 4 per cent against the US dollar. Part of it is due to the winding down of the “Trump-trade” and loss in the dollar globally. As market participants have become sceptical about the implementation of Trump’s agenda, they have been cutting down long-dollar positions, and emerging market currencies in general have gained this year.

Meanwhile, there has been a host of factors on the domestic front leading to substantial gains in the rupee. After the BJP’s landslide victory in the latest Assembly elections, foreign investors have turned more hopeful on the Indian equities. Since the announcement of the election results on March 13, FIIs have poured in $3.4 billion into Indian markets, compared to an outflow of similar magnitude in the first ten months of FY17.

Another major change has been in the outlook of the policy rate. The Reserve Bank of India has turned hawkish with a change in its stance from ‘accommodative’ to ‘neutral’. Consequently, the rise in bond yields has led to an influx of foreign capital into the Indian debt market. In addition, the GDP growth for the third quarter of FY17 has been much better than expected and has helped alleviate some of the earlier fears related to demonetisation.

On the domestic front, the current account deficit is likely to widen from 0.6 per cent of GDP in FY17 to around 1 per cent of GDP in FY18, and inflation is expected to pick up from around 4.5 per cent in FY17 to 5.1 per cent in FY18 (HDFC Bank forecasts).

Global picture

On the international front, while two more rate hikes from the US Fed are factored in by the markets, political uncertainties and looming policy risks, both in the Euro Zone and the US, could lead to a ‘risk-off’ episode going ahead.

Some longstanding and others newly formed far-rightwing parties have been achieving electoral success in a number of countries. With upcoming elections in France and Germany, there could be a wave of uncertainty that could lead to capital flights from the emerging world.

Against such a backdrop, the rupee is likely to depreciate in line with other emerging market currencies in the medium-term.

However, in the short-term, as long as capital inflows remain robust, the appreciation pressure could stay intact. In such a scenario, the incremental room for rupee appreciation will largely be dependent on the intervention strategy of the central bank.

What to expect from the RBI?

In 2016, there was a reasonable degree of certainty about the resistance level of the rupee. As such, $/₹ movements below the 66.5 mark captured the RBI’s attention. However, unlike in the past, the RBI’s intervention in the currency market has not been aggressive enough this time around, due to multiple reasons. One, the current episode of rupee appreciation is viewed as a short-term phenomenon. As mentioned, with a gradual pick-up in inflation and deterioration in the current account dynamics, the rupee trajectory could reverse without any commensurate need for intervention from the RBI.

Two, there is ample liquidity in the banking sector. At the last count, systemic liquidity surplus was around ₹4 trillion. In such a situation, buying dollars and further infusion of rupee liquidity could put the RBI’s foremost goal of inflation-targeting at risk.

Three, there is strong evidence that the fair value of the rupee has changed. That is, the RBI is now likely to be more comfortable at a marginally higher level of the rupee than in the past. This is the most important aspect to understand regarding the near-term rupee trajectory.

One measure of the fair value often cited is the RBI’s Real Effective Exchange rate. For February, this measure suggested around 15 per cent over-valuation in the rupee. An over-valued exchange rate implies that the currency is too high for the state of the economy and it should depreciate for competitiveness to remain intact.

Misleading logic?

However, the contention that the rupee is over-valued based on the RBI’s measure may be misleading since it gives more weightage to the EUR and AED instead of competing currencies such as China and other Asean countries. In fact, in February, the RBI governor himself mentioned that the rupee is ‘broadly’ where it should be when its own gauge of the currency’s trade-weighted performance showed it to be over-valued. Therefore, other measures of the REER by the ministry of finance (MoF) or by the IMF, which assigns higher weightage to Asian currencies, are probably better to gauge the rupee dynamics going ahead. Using the same weights as used by the MoF, I formulated a new measure of the weighted exchange rate for India’s trading partners (nominal terms). This measure shows that since February, if on the one hand, the rupee has appreciated by 1.9 per cent against the dollar, the basket of competitive currencies has also appreciated by 0.6 per cent. This still leaves an unexplained appreciation of around 1.3 ppt. Hence, to take inflation into account, which works with a lag of around four months, I created the inflation differential index for India using the same weights as the Asia REER measure of MoF. This shows that since October, the weighted inflation differential for India has gone down by 1.3 per cent. This is what explains the additional appreciation that has occurred in the rupee.

In a nutshell, while globally other currencies have appreciated too, the decline in India’s inflation has been more than that of its competitors thereby leading to a re-rating of India’s exchange rate.

Thus, it would be safe to assume that the RBI will not become an aggressive buyer of the dollar until the exchange rate slips below the 65 mark. Of course, in the medium-term, as inflationary pressures pick up, this fair value estimate would undergo a gradual change.

(The writer is a senior economist at HDFC Bank. The views are personal. The article first appeared in The Hindu BusinessLine.)