After the US Federal Reserve indicated that it would taper off the quantitative easing (QE) program most emerging market equities took a beating. Along with equities their respective currencies also came under the hammer. The reason was simple. Gradual tapering of QE is an indication that the US economy is recovering and therefore no longer needs additional doses of liquidity.
It may be noted that the liquidity injection exercise in the form of QE led to a flow of money across borders. But with Fed indicating that the stimulus program might well end soon investors started to withdraw their money from foreign markets. In short, emerging market equities fell. There was a sharp fall in prices of all asset classes, and emerging market currencies were not spared either. Rupee was no exception here. The Indian currency recently touched the 60 dollar mark.
But the question is whether the current fall is just a knee jerk reaction or are there some structural problems associated with the fall?
Well, it's a combination of both. There is no doubt that the recent sell off in equities/bonds by foreigners has resulted in rupee's fall. But it may be noted that there are structural problems associated with the currency which further accentuated the fall. Rupee was already under pressure before the announcement on QE withdrawal due to India's widening current account deficit (CAD). And the recent sell off in equities/bonds by foreigners further increased rupee supply. This added fuel to fire. At the same time, the current investment climate is not very conducive for foreign investors either. As such, the dollar inflow in the form of foreign direct investment (FDI) and foreign institutional investment (FII) was muted. In short, there was no support for rupee which led to a free fall.
Another important point to note is that fearing further rupee depreciationforeign institutional investors (FIIs) sold off their rupee bond portfolios. With rupee depreciating the returns of FIIs in dollar terms were eroding. Hence, they indulged in selling their bond portfolios. The selling pressure was further worsened when the interest rate arbitrage between the two countries started narrowing. It may be noted that US treasury yields are 2% while government bond yields in India are 7%. As such, there is an arbitrage of 5% (odd) if one borrows in US dollars and invests in Indian bonds. But rupee depreciation wiped this arbitrage which triggered further selling of rupee bond portfolios.
We feel that unless India's domestic environment becomes investor friendly rupee would continue to suffer. Narrowing CAD could help to some extent. Though government did take steps in this direction by curbing gold imports this is a short term measure. The RBI has limited fire power (in the form of forex reserves) to intervene in the currency markets and arrest the fall in rupee. Thus, realistically government has to take steps to attract dollar investments to support the rupee. Else the road ahead for the Indian currency would be a bumpy one.