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Indian Rupee: What lies ahead?

May 15, 2007

The Rupee in the past one-month has appreciated from around 42.67 per dollar to 40.60 levels, hurting the sentiments of export oriented sectors, notably that of software, the stocks of which have been hit to quite an extent (the BSE IT index fell by 4%) during the same period. In this article, we shall take a look at what has caused the rupee appreciation and whether this phenomenon is likely to sustain going forward.

What has caused the sharp appreciation?
Inflation (WPI), which stood at 4.1% at the end of March 2006 increased to 5.7% at the end of March 2007. The same had reached an intra year peak of 6.7% at the end of January 2007. In a bid to check inflation, the RBI had raised cash reserve ratio (CRR) for the banking sector by 50 basis points to 6.5% in April and the 'repo' rate from 7.5% to 7.75% to curb the excess liquidity in the banking system. With the dollar inflow into the country remaining strong, the rupee appreciated considerably with the RBI choosing to stay on the sidelines. The reason for the same was obvious. While the Reserve Bank of India (RBI) in the past has been active in intervening in the foreign exchange markets, had they bought the dollars this time, more rupees would have been released into the financial system, thereby negating its aim to cap the liquidity. This caused the rupee to touch a high of 40.58 on April 25, 2007.

Meanwhile, the flow of dollars into India has continued unabated. Net invisible earnings amounted to US$ 40.5 bn in the period April-December 2006 as against US$ 28.1 bn a year ago led by buoyant exports of software, transportation services, the continuing strength of remittances from Indians working overseas and the growing net exports of various professional and business services. Gross FDI inflows increased to US$ 16.4 bn during April 2006 to January 2007 from US$ 5.8 bn in the corresponding period last year. (Source: RBI). Besides this, the Foreign Institutional Investors (FIIs) have also poured in money into Indian equities. To put things into perspective, in the period between January-April 2007, the amount of FII inflows have been pegged at US$ 3 bn with the majority of it coming in the month of April (US$ 1.5 bn) (Source: SEBI).

Is this likely to be sustained?
However, the key point here is whether this rise in the rupee is likely to be sustained and for how long. While it is difficult to take a call on the same, we believe that there are certain inherent factors that will likely keep a check on the appreciation of the rupee.

Oil imports: India currently imports around 70% of the oil that it consumes. During April December 2006, while non-oil imports posted a growth of 18.6%, oil imports increased by 39.2% due to the firm international crude oil prices and strong volume growth (Source: RBI). It must be noted that there usually tends to be a downward pressure on the rupee during the end of every month owing to the rise in the demand for dollars as the oil importers look to meet their import obligations. Having said that, in the longer term, unless India achieves sufficiency in oil reserves consequently, easing the quantum of oil imports, the sustenance of a stronger rupee is most likely to be put to the test.

Deficit scenario: The merchandise trade deficit increased to US$ 52.3 bn during April-December 2006 from US$ 40.1 bn in the corresponding period last year (Source: RBI). Typically, in a trade deficit scenario, depreciation of the rupee makes sense as a weaker rupee will make exports more competitive thereby easing, to some extent, the pressure on the trade deficit. Thus, an appreciating rupee could increase the pace of imports going forward and likely aggravate the deficit situation. With the demand for oil remaining largely inelastic, the quantum of exports needs to be scaled up going forward.

To sum up...
While the rupee appreciation is expected to hurt export oriented sectors such as software, pharma and textiles amongst others in the near term, looking at the other side of the coin, the same will reduce the burden of servicing and repaying of foreign debt of companies that have raised dollar denominated debt. That said, we believe that, in the long-term, the Indian rupee is likely to be weaker against the greenback. Therefore, in such a scenario, while it is not possible to completely eliminate forex risks, those companies that adopt prudent hedging strategies will have that extra edge over their peers.

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