The rupee had everyone on the edge of their seats in August this year as it threatened to crash below 67 against the dollar and speed towards the ignominious low of 68.8 recorded in August 2013.
On both occasions, at surface level, it appeared to be global events that had caused the turbulence. It was the threat of the Federal Reserve beginning the taper of its quantitative easing programme that ostensibly began the sell-off in 2013. The recent sell-off was due to fears of a global slowdown led by China, compounded by the threat of the Federal Reserve embarking on monetary policy normalisation.
While it might appear that the rupee dances to global tunes — as foreign investors pump in money or pull it out depending on global events — this is far from reality. An analysis of the linkage between rupee movement and foreign fund inflows shows that these flows no longer play a dominant role in influencing the long-term movement of the currency.
It is the trade balance, notably the movement in crude oil price and export growth, that wields a greater influence on the Indian currency.
Foreign fund flows and the rupee It is widely believed that the destiny of the Sensex and the rupee are tightly entwined; the connecting link is said to be foreign fund flows.
But this is not so. While foreign fund flows do seem to affect the sentiment in currency markets in the short term, it does not have a long-term effect. Foreign investors of all hues — foreign portfolio investors, foreign direct investors and NRIs — have only been pumping money into India over the last five years. And despite this, the rupee has moved in only one direction — south.
If we consider table 1, since 2009, there have been many years when inflow of foreign investment money has been very strong, resulting in a strong rally in the Sensex. But the rupee has declined in those periods.
For instance, in 2014, the country received the highest ever FPI and FDI inflows at $42 billion and $34 billion, respectively. NRIs chipped in with inflows of another $11 billion into bank deposits. The Sensex scaled new highs and ended the year 29 per cent higher. But the rupee remained lacklustre, losing 2.7 per cent against the dollar. In 2009, when $18 billion of FPI flows lifted Indian equity prices from bear-market lows, the gain in rupee was a very sedate 4 per cent.
The correlation co-efficient between the movement of the rupee and the Sensex was extremely weak at 0.01 in 2014 while in 2013 there was negative correlation between the two. The correlation coefficient is a number between +1 and −1 that represents the linkage between two sets of data. The numbers in 2014 and 2013 imply that the Sensex and the rupee are not inter-dependent. The link between foreign fund flows and rupee is also weak.
The correlation between foreign portfolio flows and the rupee was less than 0.5 in 2014 and 2013.
What it means: India will remain a hot destination for FPI and FDI investors due to relatively superior economic growth and attractive real interest rates. But these are not likely to help the rupee.
Rupee and trade deficit It is, therefore, apparent that foreign fund inflows are not the salve for all of rupee’s ills. If we consider the 50-year history of the rupee, it has been in a structural downtrend, consistently trending lower. In 1973, one US dollar could be purchased for 7.58 rupees. Those were the days of managed currency when the rupee value was not allowed to reflect the demand and supply in the market. The slide became sharper after the nineties when the economy was opened up and rupee was sharply devalued.
The primary reason for this structural weakness in rupee is the consistent trade deficit that the country has been running. There are three components of the trade deficit that seem to have a major influence on the rupee movement.
The first is, of course, the crude oil movement. With crude imports accounting for over a third of our imports, sharp increase or decrease in crude oil prices has made the rupee also swing. The inelasticity of demand for crude in the country strengthens this linkage.
The rupee recorded one of its sharpest declines in 2008-09 when value of crude imports had surged 17 per cent due to the increase in global crude oil prices. In 2011-12, the rupee lost 6.4 per cent as petroleum products imports surged 46 per cent. On the other hand, the decline in rupee value has been more subdued since FY 14 as value of petroleum imports has tapered down following the price correction in crude oil. Imports of petroleum and its by-products have only been rising in recent years, from $93 billion in FY 09 to $138 billion in FY 15, adding to the pressure on the currency.
The other factor in the country’s external trade that influences the currency is gold prices. Following the 2008 crisis, given the negative real returns from bank deposits and other fixed income investments, Indians started putting their savings into physical assets, including gold. Indian gold imports more than doubled from $21 billion in 2008-09 to $57 billion in 2012-13. That the prices of gold spiralled higher in this period only exacerbated the imported value.
In FY 12, a sharp increase in gold imports to $56 billion was one of the reasons why the rupee started reeling lower, triggering the 2103 currency crisis. Since it is easier to clamp down on gold consumption rather than petrol, the government went all out to curb gold imports in 2013. But with the easing of import restrictions, gold imports are beginning to crawl higher again.
While in earlier years, the impact of surging imports could be partly neutralised by exports, this is becoming difficult of late, due to the slackening export growth. Merchandise export growth hit a recent peak of 40 per cent in 2010-11 and has been sliding down since then. There is a contraction in merchandise value of exports so far in FY 16. The story is similar in services exports with value of services exported showing a contraction in FY 16 after slowing down over the last three years.
This is perhaps why despite the relief on crude oil and gold prices, rupee continues to stutter over the last couple of years. This has implications for policy-makers and the ongoing Make in India campaign also gains greater significance when viewed against the backdrop of these numbers.
While the ongoing slowdown in global economy is impacting our export growth, there is much that can be done to improve merchandise exports from the country, too.
What it means: With crude oil and gold prices expected to be subdued, rupee will get some relief. Slowing export growth is, however, a weak spot for the rupee.
Inflation and REER The long-tem movement of inflation has also been conducive to the rupee. The Wholesale Price Index, which was more widely tracked until a couple of years ago and has comparable data going back many years, has been heading lower since the late nineties when the reading was around 20 per cent. While there were a couple of peaks in 2008 and 2010 when the index reached 10 per cent, it has been moving lower since then, declining below zero, into deflation in 2015.
A high inflation erodes the competitiveness of the currency and the decline in inflation is among the factors contributing to the rupee’s strength.
This decline in inflation has increased the value of the rupee vis-à-vis its trading partners. The 36-currency weighted Real Effective Exchange Rate (REER) that measures the value of the rupee against its trading partners’ currencies after adjusting for inflation currently reads 110, as of end of September, implying a 10 per cent overvaluation of the rupee currently.
But it needs to be noted that the REER uses the WPI for calculating the rupee’s competitiveness and might not be an accurate measure.
What it means: Declining inflation is another plus for the rupee.
The dollar equation This one is a no-brainer. The strength in the dollar is one of the main determinants of the rupee movement.
If we consider the recent history of the rupee, a fresh bout of depreciation began in July 2011. This reversal coincided perfectly with the dollar index hitting the low of 73 in August 2011 after S&P downgraded US credit rating one notch below AAA.
The dollar has been on a roll since then, thanks to the weakness in the euro caused by weaker Euro Zone members and due to the superior growth in the US economy.
A near zero rate of interest in US has also given rise to greater demand for dollar loans that were, in turn, used to buy assets in other countries. While the dollar index has gained 30 per cent since early August 2011, the rupee is down from 44 to 65 against the dollar in this period.
What it means: The rupee faces threat of further depreciation if the dollar heads higher once the Federal Reserve starts hiking rates.
Takeaways The takeaway from these numbers is that it is a waste of time to attempt to gauge the direction of the rupee movement through foreign investment flows. While they do cause short-term gyrations in asset prices, the value of the currency appears more influenced by the external trade numbers and the movement of the principal commodities it imports.
With the global oil producing majors operating with varied agenda, price of crude oil is likely to remain tepid for some time. This should provide a big reprieve to rupee. It may be recalled that rupee had been among the most resilient currencies so far this year. This is mainly due to the benefits arising from slide in crude oil prices.
The price of the other bugbear of policy-makers, gold, has also been heading lower as investment demand has dried up. There is unlikely to be an upsurge in gold prices though Indian demand for gold jewellery will need to be kept under constant vigilance.
The decline in inflation also plays in the currency’s favour, making it strong relative to its peers. The global slowdown and the consequent impact on the exports is, however, a worry for the rupee right now.
A global risk-off trade that results in a sharp increase in dollar value as money is repatriated back to the safe-haven of US dollar denominated securities is the biggest threat facing the rupee currently.
Such an event can pull the currency to 72-75 against the dollar. But for this risk, the 60 to 70 range should hold the Indian currency over the coming year.