Column

The RBI finally stepped in to the rescue of the Indian rupee last week. The central bank sold dollars as the rupee-dollar pair rose past the 43 level and touched 43.17-43.20. That helped to ease the pressure on the Indian unit, which remains undermined by the rising crude oil prices.

During the week surging oil prices, served another reminder to the market participants about the worsening trade deficit position. Crude oil prices touched a new high of $135/bbl during the week and finished the week higher by another 4%.

Since the beginning of this fiscal year, the price of crude oil has risen by $30/bbl and the year-to-date average price of India’s crude oil basket is now over $110/bbl. This is $37.5/bbl higher than the average price of $72.5/bbl for the last fiscal year.

Assuming that the average price remains at $110/bbl for the rest of the fiscal year, then our annual crude oil import bill would rise by about $41.3 billion. This would mean that about an extra $3.5 billion will be required every month to meet the oil import bill.

That number will only grow bigger with the rising oil prices, as with every $1 increase in the price of crude oil, the import bill goes up by about $1.1 billion. In the absence of adequate capital inflows to fund such a demand at the moment, downward pressure on the rupee is inevitable.

In this backdrop, the Indian central bank’s exchange rate policy and its actions in the currency market assume critical significance. The RBI support for the rupee is necessary to arrest this erosion of value. Without its support, the rupee depreciated by 6.4% in the four week period prior to last week. By choosing not to act during that period, the RBI seems to be signalling that some depreciation of the rupee is justified for maintaining export competitiveness.

The central bank is, therefore, more concerned about the inflation-induced overvaluation of the rupee in real terms. Inflation has risen sharply over the last two months and is currently hovering close to 8%.

Given these concerns, the RBI’s support to the rupee last week could then be taken as a signal that it does not see a merit in the rupee weakening beyond the 43.20 levels in the near-term. Or in other words, the rupee-dollar rate has reached a level where the rupee is now undervalued in trade-weighted inflation adjusted terms.

That does seem to be the case, if one were to consider that the 6-country REER index with base year 2005-06 slipped to a level around 97 last week, indicating almost 3% undervaluation.

The RBI’s position of the rupee in the medium to long-term remains sanguine. That can be construed from its positive assessment of the external balances position of the country. In its April policy document, the bank stated that the current account deficit will remain manageable and net capital inflows will comfortably fund the gap.

The near-term market outlook for the rupee will remain negative considering the widening trade deficit. Market participants are also concerned about the worsening of other macro-economic fundamentals.

Rising level of inflation and the presence of strong inflationary pressures, pose a serious risk to the growth momentum in the economy. That could keep foreign investors cautious about the Indian economy and hence capital inflows could remain elusive.
Equity market underperformance too remains a cause for concern, especially given the negative impact of rising raw material costs and fuel prices on corporate sector bottomlines.

This week, the US dollar’s weakness against other major currencies could provide some limited respite to the rupee. Last week, the greenback put in its worst weekly performance for two months against the euro, as the Federal Reserve painted a gloomy picture of the US economy and oil prices hit record levels.

The minutes of the Fed’s April meeting revealed that officials expressed concerns over rising inflationary risks while downgrading their assessment of the US economy. A clear concern was indicated that the employment situation was set to deteriorate and the housing market showed no sign of bottoming.

At the same time hawkish comments from the European Central Bank, the Bank of England and the Reserve Bank of Australia dramatically altered the dovish monetary policy outlook for these central banks. As a result both euro and pound rose by 1.2% each against the greenback, while the Australian dollar climbed to a 24-year high, also getting support from rising commodity prices.

The US dollar could remain vulnerable this week too, as a host of data releases including consumer confidence, personal spending, new home sales and durable goods could prove bearish for the greenback. These data points are likely to paint a gloomy picture of the US consumers who continue to struggle under the weight of deteriorating personal finances.

This week the rupee-dollar pair could trade in a range of 42.50-43.20, an almost similar range of 42.45-43.20 last week. In case the pressure builds up from another spiral in the oil prices, the RBI could step in to arrest the rupee’s fall.

And, if the RBI prevents the rupee to fall beyond the level of 43.20, the rupee could get some support from exporters dollar sales. They have been on the sidelines waiting for the rupee to weaken further.

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