What’s Behind the Declining Rupee ?

The Indian rupee, which is known for being mercurial, has only cemented its reputation after its recent sharp slide to a record low, dropping from 56.51 rupees per dollar on May 31 to 58.41 on Thursday. However, the currency’s poor performance began earlier this year — since late April, the cumulative decline has been 8.7 percent, with a 4.2 percent fall in May alone.

A falling rupee is a concern because it is a signal of weakness to the external world, and a weaker currency makes it more expensive to buy imported goods like oil, which in turn aggravates the problem of inflation. And a softening rupee increases the implicit cost of India’s high foreign debt.

The government’s reaction has been predictable: Officials like Finance Minister P. Chidambaram have been assuring the public and investors that the drop in the currency is a temporary phenomenon that has also been witnessed in other countries and that they are working at stabilizing the rupee by addressing issues that affect the inflow of capital.

The question, however, is whether their reassurances are enough to stem the rupee’s fall. To answer that, we have to look at the two sets of factors working to undermine the rupee. The first is fundamentals and the other is sentiment, both domestic and global.

At the basic level, the rupee falls when more money is coming into the country than what is leaving. Foreign institutional investor flows have been negative for all the trading days in June (for a total of $2 billion), though they were positive in May ($4.4 billion). But what is more important is that foreign investors have been moving out of debt, which gives a signal to the Reserve Bank of India, or R.B.I., to avoid cutting interest rates in the near future.

The second fundamental factor involves the country’s trade deficit, which is becoming a more serious problem, judging by the government’s mounting concern about gold imports. The latest comments came Thursday from Mr. Chidambaram, who pleaded with Indians to stop buying gold. Gold and oil constitute around 45 percent of imports, and with oil price remaining steady, evidently gold imports have upset the apple cart.

Further, one can surmise that foreign direct investments and other inflows have not quite made up for the trade deficit, as evidenced by a decline in the country’s foreign currency assets by $3.1 billion in the last week of May. Clearly, India’s balance of payments has turned perverse, which justifies a decline in the rupee.

However, investor sentiment is also playing a critical role in the rupee’s accelerated slide, and this germinates from both global and domestic waves. At the global level, investors have been worried that the Federal Reserve will end its government bond-buying program, which was designed to keep American interest rates low to stimulate the economy, after the Fed chairman, Ben S. Bernanke, suggested that the program may be scaled back in the near future.

The implication is that if this happens, then the foreign funds that have been moving to emerging markets looking for better returns will return to the United States once bond yields there firm up. This would mean that there will be fewer flows to these developing countries, including India, which would pressure the balance of payments and in turn the domestic currency.

This explains to a large extent an apparent paradox in the global currency market, where the dollar has been weakening against the euro, yet has strengthened against the currencies of most emerging markets that have been recipients of fund flows. Brazil’s currency has depreciated 7 percent in May, while the Mexican peso has fallen 4.9 percent, the South Korean won by 2 percent and the Russian ruble by 3.5 percent. This is a point that the Indian government has been emphasizing, that the rupee’s fall is part of a global phenomenon and so there is no reason to worry as things will settle down eventually.

The problem is that when fear sets in the foreign exchange market, it often reinforces the fundamentals. The threat of a further decline in the currency causes importers to rush in to buy dollars while exporters will hold back their dollars for conversion, thus exacerbating the demand-supply gap. This is where the Reserve Bank of India intervened last year, by forcing exporters to bring in their dollars when the rupee fell to its previous low.

The other sentiment wave flows domestically, from the government and the Reserve Bank of India. The more the government and central bank point out that the gold import situation is serious, the more investors believe that economic conditions are worsening and that nothing much can be done to control the slide.

In addition, investors keep expecting these authorities to comment on the dollar, but it’s a Catch-22 for the officials: if they say something that is perceived negatively by investors, the rupee will weaken further, but even if they stay quiet, investors may interpret the silence as a tacit acceptance of the current decline, which would cause yet another sell-off of the rupee. In fact, the free fall of the rupee that caused it to cross the 58 mark on Monday and near the 59 mark on Tuesday can be attributed to these sentiments. This is okay.

Rupee depreciation does have its advantages since it makes Indian goods cheaper overseas and therefore more attractive to consumers, which benefits exporters. But these days, exporters may not actually see significant gains as the global economy is still stagnant and the price advantage on exported goods may not materialize any time soon given their relative inelasticity. In fact, some importers of Indian goods are asking exporters to lower their prices on account of this price advantage.

So, with all eyes on the rupee, investors are waiting for central bank to intervene in the market. This usually starts with some large public-sector banks selling dollars in the market, which could have been one reason for tempering of the rupee’s fall on Tuesday. The second defense is through direct intervention by the R.B.I. to sell dollars in the market. This will directly affect not just the fundamentals but also sentiment. But given that India’s foreign currency assets have at best been stable at around $ 260 billion, there are limits on such intervention.

Under these conditions, it looks unlikely that the R.B.I. will lower interest rates at its next meeting on Monday. The focus will be on ensuring stability in the foreign exchange market before taking further monetary policy action. The recent upgrade in India’s outlook by Fitch Ratings will be a comforting factor, and the R.B.I. will try hard to get the rupee in order before pursuing its goal of easing interest rates to take the economy forward.

Madan Sabnavis is chief economist at Care Ratings, a credit rating agency based in Mumbai.

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