By Vasan Shridharan, Treasury Economist, Standard Chartered Bank
What a difference a year makes. This time last year, the Indian rupee (INR) was remarkably stable. It was comfortably ensconced around the 43.30-43.50 level against the greenback. Bias, if anything, was then for the home currency to appreciate as India’s digital credentials drew like a magnet, a flood of international dollars. Both the onshore and offshore INR yield curves shifted dramatically lower. The good days extended well into the spring season. But the summer brought bad tidings. As the animal spirits governing global tech investment decisions evaporated, foreign capital started exiting India.
All downhill since May, the currency has shed a resounding 6.5% of its value against the greenback to stand at 46.6 as of this writing. Whilst mild in comparison to the losses of many of its Asian counterparts, the INR’s performance has, nevertheless, shaken faith in its defensive investment credentials. Yield players, dealt a severe blow, have taken to the sidelines. The onshore government curve has drifted considerably higher, as has the non-deliverable forward (NDF) swap curve.
Fears of a sharp mark up in US interest rates were what first provoked the bearishness for Indian assets this year. By enhancing the prospective return on ‘risk-free’ US Treasuries, these fears engendered a profound adverse readjustment in the allocation of global portfolio capital towards the peripheral emerging markets. The INR felt the heat of this dynamic during the summer.
But even as US rate concerns have taken a backseat during recent times, a new stress point has emerged for the Indian currency: the continuing robustness of international oil prices. Incessant crude output increases sanctioned by the OPEC community have failed to cool a white-hot oil market. Indeed, higher oil prices are now projected to lift India’s fuel import bill a hefty 50% y/y to US$19 billion and the current account deficit (CAD) to a decade-high level of 2.4% of GDP in FY 00/01 (fiscal year ending March 31, 2000).
Trade channel apart, they are also perceived to be brewing troubles through the investment channel. By moderating domestic absorption and cutting into corporate earnings, they are seen subduing foreign portfolio investments. The overall deterioration in the outlook for the country’s balance of payment (BoP) has predictably fanned significantly softer INR forecasts for the balance of the fiscal year. Estimates of 48-50 are being freely bandied around in a section of the market. The upshot has been the creation of a new negative dynamic equilibrium.
Exchange rate policy
Now that the INR appears to be caught in a bear grip, the big question is whether the Reserve Bank of India (RBI) will attempt to extricate it from further declines or not. The answer to the question lies not as much in the central bank’s ability as it does in its policy intent.
Armed with the dollar funds generated by the State Bank of India’s (SBI) deposit issuance to the scores of expatriates the world over, the RBI is not in shortage of resources to arrest the INR’s weakness in what remains a tightly controlled and closed market structure. Yet, if until now, it has not perhaps played all its cards and reined in the INR whole-heartedly, it is only because the central bank wants to safeguard the competitiveness of Indian exporters in the international goods arena.
The confluence of the euro and pound’s rash tumble and the higher domestic inflation rate over the past quarter has incessantly rendered the real value of the INR overvalued. A higher USD/INR cross is helping to keep local exporters on an even keel and rev up one of the key engines of economic growth this year. Indeed, without the sterling performance from the export sector, India’s GDP would have struggled to better 5.5% y/y in FY 00/01. But now, with a helping hand from the government, it should manage 6% y/y in line with the RBI’s current forecasts. All of this brings us to the basic point: without a stabilisation in the European currencies, the central bank’s defence of the INR will not be stout.
US interest rates key
INR bears are quick to wish good luck on that ‘stabilisation’ count. In the eyes of many of these players, the euro’s downside still remains wide open. Yet, it is worthwhile stressing the fact that chinks are steadily showing up in the US economic power-machine more glaringly today than anytime before over the past year.
The confluence of lateral equity market movements, higher oil prices and the Fed monetary tightening spree over the past 12 months has tempered Q3-00 GDP growth to 2.7% y/y ‘ a far cry from the scorching 5.5% mean pace of the previous four quarters.
Significantly, the slower US economic growth has been accompanied by a considerable deterioration in the credit conditions. To be sure, these developments do not yet add up to a core hard landing scenario, but they can no longer be consigned to the tail end of the normal distribution curve.
In the event they do threaten to hit growth dramatically, the Fed will have to assess its options in H1-01. A rate cut could follow and the USD could lose its pole position against the other major currencies. For Indian corporates with unhedged dollar liabilities, the sooner that happens, the better it will be.