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Capital controls, credit crunch will induce slower rupee appreciation

MUMBAI: Year 2007 will go down as a watershed year for the rupee. The Indian unit appreciated by about 11% against the US dollar and outperformed other major currencies too, except for the euro. The rupee also emerged as the second strongest currency in Asia, after the Thai bhat. This was an unprecedented show of strength for the rupee.

While this sharp appreciation in the rupee was clearly driven by the surge in capital inflows into the country, the fact that the Reserve Bank of India allowed the Indian unit to strengthen was equally important.

The central bank pursued limited intervention between April and June and that saw the rupee rise sharply against the greenback during that period. The RBI, however, stepped up its dollar buying in the second half of the year and applied brakes on the pace of rupee appreciation, especially since portfolio inflows rose sharply on the back of rate cuts by the US Federal Reserve.

A shift in the RBI’s stance towards the rupee’s strength came about because of severe inflationary pressures, especially those emanating from costlier imports of crude oil and even food. Headline inflation had risen well above 6% at the start of the year itself, much to the RBI’s and the government’s discomfort. And given that excessive capital inflows were behind this surge in inflation, the RBI let the exchange rate of the rupee adjust to a new equilibrium level before stepping up its intervention to absorb the inflows.

Capital inflows into India touched a new high in 2007. This was visible from a massive $95.4 billion increase in the RBI’s foreign exchange reserves during the year. While external commercial borrowings (ECB) constituted the largest chunk of these inflows in the first half of the year, it was portfolio inflows which were the main contributor for the whole year. FII inflows amounted to $17.4 billion in 2007, while a net $13.7 billion flowed in through the ECB route in the first half.

FII inflows were buoyed by the strong investment driven growth momentum in the economy and that drove up the BSE Sensex by over 47% in 2007. FDI inflows were also relatively larger and private equity deals brought in about $15.6 billion.

Therefore even as the current account deficit ballooned over the year, the rupee enjoyed a bull run, as capital inflows far exceeded this deficit. A stronger rupee did prove effective in curbing imported inflation and by the end of the year, WPI inflation had eased to 3.45%.

Excessive capital inflows and the resultant difficulty of managing them without either stoking inflation or letting the rupee appreciate further, also prompted the government to introduce capital controls to curb inflows from the ECB and the portfolio fronts.

International price action also helped the rupee. The US dollar, which has been declining since 2002, finished yet another year with heavy losses against other major currencies.

Its decline was particularly sharp since August, as the subprime housing market crisis came out in the open and the Fed was forced to cut its rates four times. On a broader trade weighted basis, for last five-and-a-half months, the dollar’s decline rate was 9.7% per annum.

While 2008 would also be a promising year for the rupee, the pace of appreciation is likely to be slower and the rupee-dollar pair is likely to see much more volatility. One of the key reasons behind this is that the economy could see lower capital inflows compared to 2007.

The credit market crisis is still unwinding and it appears that it would perhaps take another six months to fully know the extent of writedowns and losses related to subprime exposure of various financial institutions, particularly in the US.

This would mean that investors’ appetite for risk and their ability to take leveraged bets would remain constrained till then and that it turn would induce a lot of market volatility. In this backdrop, riskier asset classes like equities would remain under pressure. And this could translate into lower portfolio inflows in Indian equities. Even concerns of market overvaluation could see lower FII inflows this year.

Capital controls put in place in 2007 are also proving to be successful, especially on the ECB front, and they are unlikely to be relaxed this year. In fact there is a possibility that some restrictions could be put on private equity inflows. At the same time, the current account deficit is likely to widen further, as the merchandise trade deficit would balloon on slower export growth and record high oil prices.

That said, overall capital inflows are likely to exceed the current account deficit and hence support rupee appreciation. The RBI on its part is unlikely to go in for faster rupee appreciation and hence would continue to intervene.

International price action would also remain supportive for the rupee, as the US dollar’s decline is likely to continue this year too. More importantly, the Chinese authorities, grappling with a surge in inflation, could consider a faster appreciation of the yuan too. That will be beneficial for all the Asian currencies.

The author is senior economist, ABN Amro Bank. Views expressed herein are personal.
E-mail: gaurav.kapur@in.abnamro.com