Receding capital inflows to put rupee under pressure

Depreciation pressures on the Indian rupee are mounting. Surplus capital inflows, over and above those needed to fund the current account deficit, have grown in size over last few years. That has fuelled rupee’s appreciation, particularly its rapid climb this year.

This scenario, however, is likely to change unfavourably for the rupee going forward. Inflow of foreign capital from two main sources - portfolio investments by the FIIs and external commercial borrowings (ECBs) by the corporate sector - can witness some deceleration over the coming months.

On the ECB front, new guidelines issued by the government on August 7 will restrict the inflow of dollars from this route. A company raising money abroad through ECBs can now only bring in upto $20 million into the country for their rupee expenditures, that too after prior approval from the Reserve Bank of India. Any amount over and above $20 million would have to be used for permissible foreign expenditure.

The negative impact of these capital controls on the rupee is likely to be limited in the short-term. Market players seem to be thinking along similar lines. On Wednesday, the rupee-dollar rate slid to a level of 40.752 in response to the news of these controls, but recovered most of its losses to close the day only slightly weaker.

The impact of these curbs could, however, be felt more significantly over the medium-term, especially if they lead to greater hedging by corporates of their existing borrowings. Such hedging activity will add to the demand for dollars.

On a standalone basis, these curbs are unlikely to lead to a sharp slide in the value of the rupee as inflows from other sources, such as FDI, are likely to remain strong. For that to happen, the inflows from the other main source, FII purchases of local stocks and bonds, need to dry up too. And, chances of that happening over the next few months are increasing. With the problems in the global credit markets worsening, investors are cutting down their exposure to all risky asset classes such as commodities and equities.

Last week’s credit market woes triggered by the turmoil in the subprime mortgage market in the US, threatened to turn into a full blown global financial system crisis. The temporary closure of three investment funds by BNP Paribas highlighted the mounting troubles in credit markets. This kept investors away from risky assets and such risk aversion led to a dry up of liquidity in money markets, prompting a rare concerted effort by major central banks to inject liquidity.

Given this backdrop, FIIs are unlikely to bring in fresh money into India in the near-term. Risk aversion is affecting their appetite for Indian equities too. After having invested $7.8 billion in local assets over the four-month period from April to July, the FIIs turned net sellers in August with net sales of $269 million. Over the medium-to-long term, India will remain a key investment destination. And the strong corporate sector performance in the April-June quarter, will only buttress the case for Indian stocks on a fundamental basis.

While the capital inflows could recede over the coming months, the RBI is reinforcing its strength to curb the rupee appreciation through its market intervention. Last week, the government raised the limit of outstandings under the Market Stabilisation Scheme (MSS) by Rs 40,000 crore to Rs 1,50,000 crore.

The RBI has been using this tool to sterilise the rupee liquidity created largely out of its dollar purchases from the market. A higher MSS limit, with a recent CRR hike, have made it easier for the RBI to intervene without leaving too much surplus liquidity in the banking system.

Changing perceptions about robust capital inflows with the ongoing global problems and the new ECB norms, led to the rupee depreciating by 0.7% against the US dollar. The rupee-dollar pair traded in a range of 40.35-40.752 over the week. This week, too, downward pressures could outweigh the positives and the rupee may trade in the range of 40.50-40.85, with a bias to depreciate.

The Indian unit’s losses could be contained by a weak outlook for the US dollar. This week’s US economic calendar confirms fears of further weakness in the greenback. Although retail sales figures are expected to remain positive for the month, consumer price inflation, trade balance and net foreign securities data are all expected to show declines.

Last week, the US dollar emerged at the top, helped by the inflows into safer assets like the US Treasury bonds and Fed’s optimism on the economy. The greenback outperformed both the European majors and even gained against the yen, which was favoured by the rush among investors to take risk off the table.

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