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RBI allowed local currency to slip below 43 level last week on the back of record oil prices

Mounting downward pressures saw the Reserve Bank of India finally allowing the rupee to depreciate below the 43 level against the US dollar last week. After the sharp decline in the value of the rupee since April, the central bank stepped in to defend that level towards the second half of May. Its absence from the market early on last week, when crude oil prices surged past $140/ bbl and equity markets lost more ground, saw the rupee-dollar pair move past the 43 level. The central bank’s actions on the rupee front suggest that it does not want to go against the external fundamentals, which have worsened significantly over the first quarter this fiscal.

A review of the recent data clearly supports the rapid depreciation the rupee has witnessed so far this fiscal. Basically, the merchandise trade deficit has widened significantly, while capital inflows have slowed down considerably. On top of that, investor sentiment towards India has acutely worsened and that has manifested in the form of large outflows by portfolio investors.

Latest data shows that the trade deficit rose to $20.6 billion in the first two months of this fiscal, compared with $13.9 billion in the same period last year. Trade deficit is surging on the back of rising crude oil prices and buoyant non-oil imports. That is likely to push the overall current account into a larger deficit this fiscal.

The balance of payments (BoP) statistics released on June 30 showed that the current account deficit for 2007-08 widened to $17.4 billion, compared with $9.97 billion a year ago. That number is likely to more than double this fiscal.

At the same time, capital inflows required to fund this gap are likely to slow down sharply compared with last year. The capital account surplus for FY08 widened to $109.6 billion from $46.4 billion the previous year. As a result, even after funding the current account deficit, the country received massive capital inflows, triggering a sharp appreciation of the rupee. The overall BoP surplus was $92 billion, the largest ever recorded by the country.

The capital account surplus this year could come down to about half of the level of FY08. That can be clearly seen from the sharp slide in capital inflows so far this year. For instance, external commercial borrowings (ECBs), one of the largest sources of capital inflow last year, have come down sharply. During April and May 2008, total ECBs amounted to $2.5 billion compared with $6.8 billion in the same period last year. While the curbs placed by the government on such inflows largely explain this decline, unfavourable market conditions in the wake of the credit crisis have also made it costlier for the Indian companies to raise funds through this route.

The most important source of capital inflow into India, the FII investments into local equities and bonds, has been a source of outflow so far this year. Last fiscal, portfolio investments brought in over $29 billion into the economy. This year, portfolio investors are pulling money out of India on the back of a poor risk appetite among investors.

They are also worried about the double-digit inflation, worsening external fundamentals, stretched public finances, increasing pressures on corporate sector profitability and a strong likelihood of a slowdown in the economy. So far in calendar 2008, foreign funds have repatriated investments worth $6.34 billion out of Indian markets, as against inflows worth $6.26 billion in the same period in 2007.

The aggregate position of these inflows and outflows can be measured by the foreign exchange reserves holdings of the RBI. In the first quarter this fiscal, these reserves have only increased by $2.1 billion, compared with an accretion of $14.3 billion in the same period last year. For the last five weeks, the central bank’s forex reserves have actually declined by $4 billion, as it stepped up intervention to protect the rupee.

These dynamics will be at play at least for the next three months and therefore, the rupee will remain under pressure. The downward pressures are more likely to intensify.
Crude oil prices can continue their climb, thereby pushing up the trade deficit. The equities market can continue to slide further, as foreign investors remain bearish on India. The overall investor sentiment and risk appetite is also unlikely to improve in any significant manner. On top of that, if the US Federal Reserve hikes the Fed funds rate, the greenback would gain more strength.

Under such conditions, the RBI’s support will be absolutely necessary for the rupee. As was seen last week, rising oil prices and even rising levels of relative inflation can see the central bank allowing the currency to weaken. India’s relative inflation position is only likely to worsen over this quarter, as WPI inflation is likely to move towards 13%. That can lead to rapid overvaluation of the rupee in real effective exchange rate terms, if the RBI defends a particular level too strongly. In such a scenario and considering the downward pressures, the rupee-dollar pair could touch a level of 44 over the next quarter.

This week however, the RBI may not allow the rupee to slip further. Therefore, the rupee-dollar pair can trade in the range of 43.00 - 43.50 as against a range of 42.87 - 43.47 last week. Market participants the world over will watch out for the outcome of the meeting of G8 heads of state, in anticipation of any move towards controlling oil prices by supporting the US dollar.

The writer is senior economist, ABN AMRO Bank, and can be reached at gaurav.kapur@in.abnamro.com. Views are personal.