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The downward pressure on rupee is intensifying with a rash of global and local factors coming into play.

At the global level, risk aversion has heightened on signs of trouble in the central and eastern European (CEE) economies.

Moody’s Investors Service has warned that the recession in CEE economies would be more severe than elsewhere and that western banks with subsidiaries in the region risked rating downgrades.

The resultant flight to safety has meant the dollar is back in favour and equities are under pressure — both of which are negatives for the rupee. India’s economic fundamentals, both domestic and external, also remain unfavourable for the currency.

The dismal public finance situation, with consolidated fiscal deficit at 10% levels, has added to the already weak external sector fundamentals. But the situation is quite different from 2008, when the currency depreciated by over 25%.

For one, hedging patterns are much more balanced. Exporters who entered 2008-09 with overhedged positions subsequently unwound their bets and look better placed to exploit the decline in the rupee.

Importers, on the other hand, have increased hedges as the rupee kept falling.
Thus, in early 2009 (calendar), the market position was much less skewed compared with early 2008 (calendar). Consequently, there has been no rapid moves caused by rebalancing of short dollar-rupee positions.

More importantly, today, the RBI has a lot more ammunition to intervene in the foreign exchange market because of the significantly easier rupee-liquidity conditions.
The central bank has injected almost four times more rupee liquidity into the banking system in the last quarter of 2008 than it had withdrawn through its intervention in the foreign exchange market between April-December 2008.

So the RBI can support the rupee from falling sharply against the greenback without putting undue pressure on rupee liquidity and domestic interest rates. Mechanisms set up such as a special market operations window for oil companies and the swap facility for Indian banks with international branches have also helped.

The RBI, however, is constrained by the need to manage a large government bond issuance this month — Rs 12,000 crore of securities every week. It has to ensure that liquidity conditions are easy enough to help the market absorb these borrowings without putting undue pressure on yields. To facilitate this, the central bank has started buying back some bonds.

But its job of maintaining comfortable liquidity is complicated by the fact that in March, liquidity pressures develop due to advance tax payments. Given that, the RBI is also intervening in the forwards market through buy-sell swaps to negate the rupee liquidity impact of its spot market interventions.

Which brings us to the moot point: how far can the RBI let the rupee fall? The six-country real effective exchange rate is a handy diviner of Mint Road moves. As per the REER index, the rupee was undervalued by about 7.7% as of February 27. Assuming that the RBI does not mind an undervaluation up to 5%, the degree of excess undervaluation is only 2.7%.

The RBI could, therefore, be comfortable with sporadic interventions. But the extent of undervaluation, however, increases as the rupee weakens against the dollar.
To wit: As the rupee falls to 53/$, the undervaluation would rise to about 11.5% (using the February 27 exchange rates). That could trigger a stronger intervention and the RBI could look to reduce undervaluation to about 10%.

For empirical evidence to back the 10% threshold hypothesis, turn the clock back to between May and October 2007. Then, the RBI showed strong resolve to check the rupee’s ascend when it was overvalued in REER terms by close to 10%.

By that metric, the RBI can be expected to act more decisively to support the rupee at 53-53.50 per dollar levels.

The author is senior economist, ABN Amro Bank. Views expressed herein are personal.

@in.abnamro.com