Math behind the Rupee's strength - Views on News from Equitymaster

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Math behind the Rupee's strength

Jul 30, 2007

Another week, another landmark for the Indian Rupee. It touched Rs 40.20 early this week - a level last seen nine years ago. As it goes from strength to strength, the Rupee has shaken up the complacency inherent in the Reserve Bank of India (RBI) - supported-exchange rate regime.As the Indian economy gradually meshes in with its peers globally, newer and alternative avenues of funds, and their uses, are opening up for the Indian investor. This has seen a flurry of activity on a whole host of fronts. With the lowering of tax and quantitative barriers, imports surged ahead of exports as the growing Indian economy demanded more than what was produced indigenously. Software and financial service exports bridged this negative trade balance very effectively and helped this account of current transfers. These 'invisible' inflows helped shore up the FY07 current account deficit. It was a mere US$ 423 m more than what it was for the earlier year while its share in GDP shrank from -1.3% to 1.2% in FY07.

Going forward we expect the export performance to suffer as competitiveness of Indian goods and services, sold in a buyers market, reduces with the Rupee appreciating 13% YoY. But India's ever-increasing appetite for crude oil and capital goods imports will enlarge the current account deficit, gradually increasing the demand for dollars.

Source: RBI

Indians look for other funds

Despite the common perception of the sharp Rupee appreciation in April 2007 being due to foreign investment into India, the net inflows under this head for FY07 were actually lower by US$ 1.7 bn than what they were in FY06. Regardless of foreign capital pouring into India (up US$ 12 bn over earlier year), Indians with deep pockets seized the opportunity to integrate vertically through global buyouts thus pushing all those dollars out of the country yet again. Thus due to Indian corporates buying overseas assets, incremental investment into India has actually reduced from US$ 17bn in FY06 to US$ 15bn in FY07.

What actually happened was a doubling of external commercial borrowings in the last quarter of FY07. With hindsight, the RBI's raising of interest rates by 5% in as many months seems to have backfired. Expensive domestic funds made Indian corporates access dollar-denominated loans to the extent of US$ 21 bn in FY07 as compared to US$ 6 bn in FY06.

This undermined the efficacy of monetary policy in the country. So now we have a situation where the Indian corporates are bypassing the banking sector for funds (incremental bank credit over March 2007 has been negative), and are either raising it through equity (IPOs and private placements) or through overseas debt. So the good news is that the higher interest rates have not affected domestic capital formation yet. This is also evident from the robust growth of the capital goods industry.

Problems of plenty

All through the upheaval of the economic reforms process, the RBI has ably maneuvered India. It has managed to steer clear of the 1997 Asian crisis despite the IMF, there has been unprecedented growth without excess inflation, public finances are in better shape, and enough funds are available for the right investor. RBI's marriage of an appropriate exchange rate policy to support the domestic growth phenomenon was successful until November 2006 when the Rupee started to gradually appreciate against the US Dollar. However, it was the sudden inflows of the greenback since January 2007 that tested the RBI resolve to keep Indian exports competitive.

Even as the RBI tries to 'smooth the impact of bunching up seasonal of dollar inflows' (buying of dollars explained in RBI-speak), it has added significantly to the money supply of the economy. Though it has sterilised some of these inflows, there still is a lot of money sloshing around in the system that is not being lent out to deserving and productive investment projects. And this can potentially trigger another bout of inflationary tendencies or asset price bubbles within the Indian economy. Unfortunately for the RBI, this has coincided with the dollar itself weakening against the world currencies as the US economy grapples with large current account deficits and the overhang of sub-prime loans on its financial system. So the RBI has to fight that much harder to support the progressively weaker dollar. Not surprisingly, the Rupee halted its appreciation against the Euro after the European central bank recently raised the interest rates.

Domestic interest rates Key to the future

With expectations of global interest rates inching upwards as most countries face higher inflation, the arbitrage opportunity in the cost of funds will reduce. If this is accompanied by lower interest rates within India, business should flow back into the Indian financial system, stemming the tide of external borrowings.

Prospects of a brilliant future will continue to attract foreign investors into investing a part of their 'risky' portfolio into India. But her imperfect power supply scenario and the long gestation period required in righting its imbalance, will necessarily limit investments. Just as any adversity is a blessing in disguise, investment into India's shoddy infrastructure itself can potentially catapult the GDP growth into double digits for years to come. At some later date, this will set up a chain of higher foreign currency inflows that would further strengthen the Rupee. As long as India suffers from shoddy political will on these issues, progress would probably be in spurts, and that too at gunpoint, rather than a well-defined and planned exercise.

The current domestic savings of 34% of GDP and a 1.5% of GDP current account deficit will suffice for funding an annual average GDP growth of about 8% to 9%. Any surpassing of this rate can come mostly from a faster pace of growth in agriculture and/or efficiency gains across industries with extensive computerisation. These productivity gains are deflationary and will help keep Indian interest rates down, fuelling further growth on domestic funding.

For the present, the strengthening Rupee juggernaut can halt with any move by the US Federal Reserve and the European Central Bank to raise interest rates coupled with some easing of the domestic interest rates in India.


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