30 Apr 2017 15:15 IST

Red hot for how long?

The rupee is rebounding and how!

If awards were to be given for the unexpected events of 2017, the strong rebound in the rupee would be the front-runner. Towards the beginning of this year, no one expected the rupee to break out of the tight range between 66 and 68.85 that had shackled the currency for most part of 2016. But the rupee not only strengthened above the 66 level against the dollar but also went on to mark a 20-month high of 63.93 last week.

This sudden spurt of strength follows a stolid show in 2016, when the Indian currency remained unfazed by some of the significant events that spelled a sea change for global markets.

The first was the UK’s referendum in June to decide whether to stay in the European Union or not — popularly termed “Brexit”. While everyone expected the British to vote against the move, the results favoured an exit.

The British currency took a strong beating immediately after the referendum. The pound declined 20 per cent against the dollar, from 1.50 in June 2016 to 1.20 in October 2016.

Another event that marked a significant shift in the global economic order was the victory of Donald Trump in the US presidential elections. This made the dollar index break the psychological level of 100.

But the rupee was not unduly hassled by these events.

So, what’s changed now to make the rupee suddenly spurt higher? Here are the two factors that aided the rupee rally.

a) Strong foreign flows

The initial trigger that helped the rupee break the 66 level came in the second week of March this year after the BJP’s resounding victory in the State Assembly elections in Uttar Pradesh. This triggered a strong surge in Foreign Portfolio Investors’(FPIs) interest towards the Indian market.

FPIs, who had bought just $646 million in Indian debt until then, went on a buying spree after the election results. For the month of March, they bought $3.92 billion in the Indian debt segment. April has also witnessed a strong foreign money inflow of about $3 billion in the debt segment.

After selling $6.36 billion in 2016, FPIs have already poured in $7.52 billion in the first four months of this year. This inflow is higher than the $7.4 billion for the entire calendar year 2015.

The inflows into the equity segment are also showing signs of a strong pick-up this year. FPIs have pumped $6.38 billion into the Indian equity segment, which is double the $3.19 billion and $3.18 billion flows seen in 2015 and 2016, respectively.

With the first rate hike by the Federal Reserve already absorbed by the financial markets, there does not appear to be a great threat to foreign fund flows in the near future. FPI flows into debt will be strong if the rupee continues to strengthen as these are short-term flows that are greatly influenced by currency strength.

b) Weak dollar

The second factor that has helped the rupee break the key 66 level is the recent weakness in the dollar. The US Federal Reserve’s stance on the rate hike front had pushed the dollar index below 100 over the last couple of months. Also, the new US President, Donald Trump’s remark that the dollar is extremely strong put further pressure on the greenback.

After raising the Fed fund rate by 25 basis points in March, the Fed reiterated that there will be a total of three rate hikes in 2017. So, unless the Fed changes its stance and turns more aggressive over raising the rates, a strong recovery in the dollar is unlikely.

The dollar index has come under pressure since the US Fed meeting in March and has tumbled 3 per cent since then, from around 101.5 to the current levels of 98.5. The dollar index has room to fall further to 98 or 97.5 in the near term.

Inability to reverse higher from 97.5 may increase the likelihood of the index falling to 95-94 or even lower levels thereafter. Such a fall in the dollar index may help the rupee strengthen further.

Also, the recent developments in Europe had been adding to the pressure on the dollar. The UK heading for early elections in June and the ongoing French elections have triggered a sharp rally in the euro and the pound in the last one month.

The British pound, especially, is looking much stronger against the dollar. It is currently around 1.28. If it can sustain above 1.25, it can surge to 1.30 or even 1.35 in the coming months. Such a rally may cap any sharp rallies in the dollar index. The euro, on the other hand, has resistance near current levels at 1.10. A strong break above it can take it higher to 1.15 levels.

With flows set to continue and dollar on a shaky wicket, where is the rupee headed now? We scanned through some of the key macro indicators to come up with some answers.

Trade and deficit

After falling continuously on a year-on-year basis from December 2014, India’s exports are showing signs of recovery since September last year. Exports have surged 35.85 per cent, from $21.52 billion in August 2016 to $29.23 billion in March 2017. But this has failed to narrow the trade deficit as imports, on the other hand, have also surged at the same rate. India’s imports have risen 39.89 per cent, from $29.19 billion to $39.67 billion.

The trade deficit, after widening to $13 billion in November 2016, narrowed to $8.9 billion in February this year. But a 45 per cent increase (year-on-year) in imports in March has widened the trade deficit to $10.4 billion. So, if the imports continue to rise at a faster pace than the exports, there is a possibility of the deficit widening further.

Two major components that can keep the import bills higher are crude oil and gold. The outlook for both these commodities is bullish.

Crude oil prices have been volatile in recent times and have been hovering around $50 per barrel over the last few months. The prices have been volatile, between $45 and $55 since December. The bias is bullish within this range. An eventual break above $55 will increase the likelihood of oil prices surging to $60 levels.

Gold, on the other hand, has been gaining sheen from the geo-political uncertainty between the US and North Korea and from the broader weakness in the US dollar. Prices have been rallying since December from the low around $1,125 and are currently at $1,250. The outlook is bullish and a revisit of $1,350 levels is likely in the coming weeks. A strong break above $1,350 will open doors for a fresh rally to $1,400 or even $1,450 in the coming months.

Back to square one

India’s current account had improved from a deficit of $7.08 billion to $0.3 billion in June 2016. But since then, the Current Account Deficit (CAD) has been widening once again and is back to $7.92 billion as of December 2016. Given that there is low possibility of the trade deficit to improve in the coming months, there is a danger of the CAD widening further. This is negative for the rupee.

External debt

India’s external debt is also reflecting a mixed picture. While the long-term debt has come down sharply by 6 per cent, from around $398 billion in December 2015 to $372 billion in December 2016, short-term debt has not eased reasonably. Short-term debt fell 12 per cent, from about $96 billion in June 2013 to $85 billion in December 2014. But thereafter, short-term debt has been averaging around $83 billion over the last two years. However, the strong forex reserves that the Reserve Bank of India (RBI) has built up over the last couple of years can help tackle the debt situation.

RBI and forex reserves

The RBI has been building up its forex reserves consistently. The reserves have risen 7 per cent, from around $344 billion in April 2015 to $369 billion now. The strong build-up in forex reserve has also increased the import cover to 12 months from the earlier capability of covering 10 months of imports. Also, as uncertainty continues to remain on the back of geo-political tensions between the US and North Korea, these reserves can be used as a tool to tackle any unexpected volatility in the market.

Since the rupee has appreciated sharply in a very short span of time, there is also an increased expectation in the market that the RBI will intervene to arrest further strength in the currency. This can involve selling the rupee and buying dollars, which can bolster the reserves further.

Rupee overvalued

The rupee appears overvalued when the Real Effective Exchange Rate (REER) is taken into consideration. A currency is considered overvalued if its REER is greater than 100 and it is undervalued if the REER is below 100. REER is a measure of valuing a currency against the currencies of its trade partners, adjusted for inflation.

The six-currency trade weighted REER (with new base year of 2015-16) for rupee is at 106 as of March 2017 and the 36-currency trade-weighted REER is at 117, suggesting that the rupee is overvalued compared to its trading partners. Further strength can erode the competitiveness of the rupee in the international market. This is one of the factors that the RBI will take into account when deciding on its currency management policy.

Event risks

The developments with regard to the US and North Korea will need a close watch. Any uncertainty on this front may cause jitters in the market, triggering a global risk-off trade. In that event, the dollar can rally, as money starts flowing into safe havens.

The upcoming US Federal Reserve meeting will also need to be tracked closely to see if there is any change from the Fed’s current stance on the rate hike front. If the Fed hints at additional rate hikes or a faster pace of rate hikes, going forward, then that may support the dollar.

A series of key elections are lined up in the coming months, which can create volatility in the currency market. The second round of French elections is on May 7 and the UK snap election is up in June. The change in pace of developments in the Brexit process after the snap elections in the UK could be significant. Germany is heading for polls in September.

Takeaway

Strong inflows and the weakness in the dollar are positives for the rupee. But the widening deficits, strong outlook for gold and oil prices, which can increase the import bills and over-valuation of rupee based on REER, are negatives for the rupee.

Moreover, the uncertainties caused by geo-political tensions and a series of upcoming elections may cause short-term volatility, capping the upside in the rupee.

That said, the rupee can strengthen in the near term, but the strength is unlikely to sustain.

(The article first appeared in The Hindu BusinessLine.)