Column

Appreciation pressure on the rupee is gaining strength again. Buoyant capital inflows and general market bullishness in anticipation of the inflows rising in future are exerting strong upward pressures on the currency.

In the last fortnight, portfolio investments have led the charge as foreign institutional investors (FIIs) have shown renewed enthusiasm to lap up Indian equities. The FIIs have been particularly active in subscribing to the initial public offerings (IPO).

The first half of 2007 has seen a slew of IPOs, which have put India at the sixth position in the global IPO market in terms of amount raised.

So far in July, net purchases of the FIIs have amounted to $3.7 billion. In addition, external commercial borrowings also continue to bring in dollars at a healthy pace.

The RBI, however, has stood firmly in the way of the rupee’s one-way rise. On last Thursday, for instance, the central bank intervened to push the rupee-dollar rate down by almost 1%. Over the entire week, the RBI managed to keep the rupee gains under check.

As a result, despite rapid capital inflows and a sharp decline in the value of the US dollar overseas, the Indian unit finished the week at almost the same value. Price action in the inter-bank market saw the rupee-dollar rate move in the range of 40.33-40.74 over the past week.

The central bank’s resolve to keep a lid on rupee’s gains seems quiet strong. A slosh of rupee liquidity, which has been injected to a large extent by the RBI’s dollar purchases, has seen interest rates decline sharply over last few weeks, with overnight call money rate hovering below 1%.

Falling interest rates pose a threat of refuelling bank credit growth and that would only add to the inflationary pressures in the economy. That has given rise to expectations that the RBI could go slow in its intervention and let the rupee appreciate faster.

The announcement of bond auctions on Friday to mop up Rs 18,000 crore over the next 10 days is an attempt to push up interest rates and can be seen as a pointer to its continued presence in the currency market. Thus, the central bank can be expected to keep intervening in the face of rising capital inflows.

Moreover, the RBI would also be mindful of the fact that any further rapid appreciation of the rupee would hurt the country’s exports sector severely.

Several trade bodies already think that exports are likely to suffer this in fiscal year due to rapid rupee appreciation. Rupee’s strength is also taking a toll on the topline of exporters, especially in the IT sector.

Citing a stronger rupee, Infosys last week downgraded its expected performance in rupee terms for the current fiscal year.

Even the sops announced for exporters last week, are only seen as a partial compensation for their losses. The pace of capital inflows, however, is going to test the RBI’s resolve, especially in the face of limited options available to it for sterilisation.

The current global markets scenario is characterised by availability of very cheap funding, particularly from Japan and rising risk appetite among global investors. These conditions are keeping the asset prices on an upward spiral.

This is especially true for the equities market, particularly in Asia. The Bank of Japan’s monetary policy committee’s 8-1 vote in favour of keeping rates unchanged last week points to the Japanese monetary accommodation continuing for some more time.

Under such conditions, the buoyancy witnessed by the Indian equity market last week could continue on the back of FII interest. Otherwise, so far this year, overvaluation concerns (in terms of price-earnings multiples) have led to an underperformance of the Indian market vis-a-vis its Asian counterparts.

Rising oil prices, with the Brent crude now hovering around $80 per barrel, will also continue to exert a downward pull on the rupee.

The price of Indian crude oil basket, which consists of Brent and Dubai crude in the ratio of 48:52, has crept above $70 for the first time since August last year. That should keep up the demand for dollars from oil companies.

The international price action could also be unfavourable for the rupee this week. Markets main focus this week will be on the inflation scenario in the US economy.

Not only are consumer and producer prices due for release, but Fed Chairman Ben Bernanke will also be delivering his semi-annual testimony on the economy and monetary policy.

With oil prices solidly above $70 a barrel, Bernanke will need to continue to stress the upside inflation risks, which will help the US dollar. Last week, it underperformed all other major currencies and sub-prime mortgage market concerns and weak economic data pulled down the greenback across-the-board.

This week, while the range-bound movements would continue in the rupee-dollar rate pair, appreciation pressures could see rupee trading in relatively lower range of 40.25-40.60 against the greenback.

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