The Hindu : Business : A re-look at the rupee

Online edition of India's National Newspaper
Monday, Jun 14, 2004

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Business

A re-look at the rupee

Any suggestion by the central bank of the country to foreign investors to hedge their local investments could itself have an adverse effect on investor sentiment.

IT IS time for a re-look at the rupee's exchange rate and interest rates.

After its spectacular run in 2003-04 — rising 9 per cent from around Rs. 47.50 against the dollar in March 2003 to around Rs.43.50 in March 2004, the Indian currency has recently paused — and, in fact, has given up some of its gains. It has fallen by 3.75 per cent in a little over two months to quote around 45.15 now. Even by international standards, recent moves in the rupee have been volatile.

Which way will the rupee go from now? Up or down? Has the strong upward trend in the rupee, noticed from its May 2002 low of 49.05 conclusively reversed? Instead, if it continues to appreciate, will that (appreciation) be at a more measured pace than seen so far — rising 11.50 per cent from 49.05 to 43.50 in two years?

Rupee interest rates are quite exchange-rate sensitive. Measured, non-volatile moves in the Indian currency, either up or down, may not see much of a reaction in interest rates.

But current inflation or expected inflation normally has a major impact on interest rate moves. However, with current and expected inflation being more a result of supply-side issues (led principally by high oil prices) than demand-side pressures, monetary policy may not move into a tightening mode any time soon.

In any case, monetary and fiscal policy makers will be averse to losing the hard-won gains of the past few years on the interest rate front in India. From a risk premium of more than 10 percentage points — which was the norm about a decade ago — Indian benchmark yields now reflect a risk premium of 2 or 3 percentage points over most G-7 yields. (In fact, it is almost on a par with U.K. yields). This compression in risk spreads has trickled down, to some extent, to the general (non-government) structure of interest rates as well.

In a sense, the compression in risk premium on Indian yields is a reflection of the confidence that investors have placed in the Indian currency. To that extent, it is of utmost importance to ensure that confidence in the Indian economy and the currency is also maintained.

The whole issue then boils down to how the currency is going to behave.

Here, as was seen over the past two months, event risks — mainly political in nature — play a major part. By their very nature, one cannot predict the timing of event risks. The best that policy-makers and market participants can do is to visualise the worst-case scenarios and prepare accordingly. Such a strategy could possibly mitigate the adverse effects of a worst-case scenario coming true.

For instance, the central bank can possibly use "moral suasion'' methods to minimise the level of open or unhedged currency exposures — particularly among non-bank participants. One saw the Reserve Bank of India, for example, some time back, publicly stating that it would supply whatever foreign exchange was needed by foreign institutional investors (FIIs) exiting the Indian stock markets. While welcome, this statement seemed to imply that FIIs could be carrying a good level of unhedged currency exposures

Of course, any suggestion by the central bank of the country to foreign investors to hedge their local investments could itself have an adverse effect on investor sentiment. It is an unenviable situation, indeed, for the central bank to be in. Such "moral suasion'' tactics can possibly be better employed with domestic non-bank participants who have liabilities/payables in foreign exchange and who are not arbitraging between overseas and local markets.

Coming to more economic factors that can impact currency values, there has been some concern about how an eventual rise in U.S. interest rates will affect the rupee.

The U.S. rate easing cycle, of course, has ended. But one does not see rate hikes of a magnitude that can impact investment flows to a destination like India coming any time soon. At least, not till the end of this year. Even otherwise, India as an investment destination is in a different category — the nature and quantum of flows into India is small in relation to global flows and may not be materially affected by a 1 or 2 percentage points rise in U.S. interest rates. More importantly, non-investment flows (private transfers) into India are not that interest-rate sensitive and these have been substantial in recent times (around $8 to 10 billion a year). A study of prevailing currency hedging costs in the Indian market suggests fairly attractive bargains for those with unhedged currency exposures. The dollar is available at a slightly cheaper rate for forward delivery than for immediate requirements. Assuming a stepped up level of hedging generally in the market (even the rupee's latest fall from the 43.50 levels to the 45.15 levels should have resulted in some increased hedging) and a general paring down of positions, there could be a mitigation of pressures on the rupee if some worst case scenario actually comes about.

Nothing in terms of economic fundamentals has changed in the past 2 or 3 months to change the view about further gains in the rupee in the medium-term — that is, over the next one year or so. But, given the heightened political risks, expectations of a rupee at 42 or 43 by the end of the year seem remote. In the current and emerging environment, any rupee upside may not extend beyond 43.35 (the local currency's recent high).

On the downside, assuming a spacing out of the demand for foreign exchange (on account of increased hedging) and a slowing down of big ticket flows into India, one could see, at the worst, another 3 or 4 per cent fall in the rupee. A possible comfort factor for the rupee as an emerging market currency, going forward, is that the dollar globally is still under pressure and could well remain so into the second half of the year.

T. B. Kapali

(Associate Vice President (Treasury), ING Vysya Bank. These are purely his personal views and do not reflect those of his employer).

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