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Indian rupee: Scaling new heights

Nov 20, 2007

Historically, the movement of the Indian currency i.e. the Rupee has been determined by three factors namely, the amount of Foreign Institutional Investors (FIIs) inflows into the country, the movement of the US dollar against the other world currencies and the RBI's policy to intervene in the forex markets to curb volatility. The scenario today has not been different either and a combination of all the three factors have contributed to the relentless appreciation of the rupee from the levels of US$ 45 last year to the current levels of around US$ 39.30.Thus, in what way are these three factors influencing the appreciation in the Indian unit?

Dollar is depreciating
The US dollar has been under pressure as of late and has depreciated sharply against the euro, Japanese yen, British pound and a host of other currencies. This has spilled over to the Asian currencies, including the Indian rupee. The subprime mess has been one of the prime catalysts as the Fed undertook to cut interest rates to provide some breathing relief to the financial markets paving the way for a weaker dollar. The spectre of a US recession has not helped matters either. With house prices lower and credit conditions tighter as a result of the subprime crisis, households in the US will find it difficult to borrow against capital gains to support their spending thereby leading to a reduction in the latter. Rising commodity prices, especially oil, is likely to further pressurise the US economy going forward.

Surge in FII inflows
The strong growth being reported by the Indian economy and the rising interest rate differential between India and the US has accelerated the pace of FII inflows into the country. The Indian economy has been chugging along at a strong pace, which can be evinced from the fact that the growth rate in the last four years (FY04 to FY07) averaged 8.6%. In the last two years i.e. FY06 and FY07, the economy has grown at a still faster clip of 9% and 9.4% respectively.

As far as inflation is concerned, the wholesale price inflation (WPI) after reaching a peak of 6.7% at the end of January 2007, mainly due to food price shocks, dipped to 3.3% at the end of September 2007. Besides this, the Reserve Bank of India (RBI), in its annual policy statement of April 2007, placed the real GDP growth for FY08 at around 8.5%, assuming no further escalation in international crude prices and barring domestic or external shocks.

Given the likely recession in the US economy and the robust economic outlook in the emerging markets, foreign investors are shifting money into these markets in a big way and India has been touted an important region on these investors' radar. In India, FIIs have pumped in money to the tune of US$ 17 bn in 2007 (US$ 7.8 bn since the Fed rate cut on September 18) leading to the sharp rally in the Indian currency.

RBI intervention
In the early part of 2007, when the inflation was at higher levels, the RBI had refrained from actively intervening in the forex market, which would have otherwise stoked the inflation further. Towards the end of 2007, the inflation has been within the acceptable limits and the RBI has been adopting various measures to counter the impact of the rising inflows. Besides increasing the level of intervention in the forex market, the RBI is also planning to impose curbs on external commercial borrowings (ECBs) and has raised the limit of foreign investments abroad. The curb on ECBs could hurt companies, which were planning to fund their capex from these borrowings. However, RBI's guidelines encouraging investments abroad, may not find many takers given the strong pace in the growth of the Indian economy and the attractive interest rate scenario. That said, if these incessant inflows continue and the RBI resorts to buying dollars and release rupees into the system, the rising liquidity could once again raise inflation levels going forward.

To conclude...
Software, pharma and textile stocks this year have been at the receiving end given that companies in these sectors have a significant chunk of revenues coming from exports. That said, given that India imports around 70% of the oil that it consumes, the rupee appreciation has helped in easing the oil import bill, thereby reducing the trade deficit burden. Overall, given the volatile nature of the exchange rates, those companies with strong managements and sound business fundamentals will be able to weather the storm better than the others. Also, at the end of the day, while it is not easy to completely eliminate forex risks, it all boils down to what prudent risk management measures companies are adopting to hedge against the same.

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