Coming up: Rupee’s roar

The rupee is expected to roar ahead over the next 18 months, appreciating the most—by over 20% against a dollar-euro-yen basket of currencies—among the major emerging market currencies. 

The surge will be driven not so much by fundamentals as by policy and strong capital flows — and, to that extent, the rupee may not outperform spectacularly if global risks weigh down capital flows. But, other things being equal, it is on course to post a strong appreciation in the period ending December 2011, according to UBS economists.  

The rupee isn’t cheap on a historical real effective exchange rate (REER) basis, and the short-term interest rate ‘carry’ it offers is moderate compared with a few other emerging market currencies. But what’s driving the rupee, says UBS economist Jonathan Anderson, is policy that supports appreciation, rather than comparative fundamentals.

“Our economists feel that the Reserve Bank of India is among the most willing of emerging market central banks to live with currency appreciation in order to insulate the domestic economy,” he reasons.

India’s balance of payments, says Anderson, “is decently supported by continued strong FDI inflows, and despite recent protestations by the government over the level of the exchange rate, the rupee has actually underperformed the average emerging market unit in real terms over the past five years.”

Meanwhile, he adds, what makes India “unique” among emerging countries is the sheer size of its domestic fiscal deficit, and thus the imperative to keep local rates and liquidity protected.

According to Anderson, this was also occurring against higher trend inflation than during the boom of the previous decade, “which, given very strong growth, means a likely upward bias to interest rates in any case and thus carry-driven flows going forward.”

In such an environment, according to UBS India economics head Philip Wyatt, the authorities would prefer currency appreciation to rising sterilisation costs in the budget.

The logic of that argument is borne out by the rupee’s performance since UBS put out an “aggressive” call at the end of 2009 for its appreciation by end-2011. The rupee has been among the best performers in the first four months of 2010, points out Anderson; and, in his estimation, it has perhaps the best prospects for staying the course going forward.

Of course, given that such a surge will be drive not so much by fundamentals but on an environment that supports capital flows, any global risk that hampers those flows would make it more difficult for the rupee to outperform aggressively, notes Anderson.