Why Rupee may not be such a big worry

Why Rupee may not be such a big worry

The economy will adjust to the new rupee levels over a period of time. That’s because, the differential with the US is wide enough for the currency to stem its seeming freefall. Consider this: India is growing at 7% while the US is growing at 2.5%. The US Federal Reserve rates are close to 0% while the RBI’s repo rate is 8%. Ten-year bond yield in the US is 2% while it’s 8.6% here. True, macroeconomic differentials alone will not help the rupee, but, at some point in time, investors will go back to searching for higher yielding currencies. In the adjustment period, however, there will be volatility in the financial market. Investors will have to ride out the volatility and look at the bigger picture, going forward. The bigger picture still says ‘buy India’ rather than ‘sell India’. The rupee is again trending towards record lows seen last December. On Wednesday, it closed at 52.9550 to the US dollar. There is a fresh nervousness and the currency has lost 20% against the dollar in the last ten months. There does not seem to be any respite. Poor trade deficit numbers, a reversal of portfolio flows in April and broad dollar strength globally have weakened the rupee. India’s trade deficit last fiscal was at a record high of $185 billion, up more than 55% from the preceding fiscal’s number. The widening trade gap has taken up the current account deficit (CAD) to 3.6% of GDP from 2.6% in 2010-11. Foreign institutional investor (FII) flows were negative in April, the first time in 2012, on worries of General Anti Avoidance Rules (GAAR) issues. The dollar index, which tracks the greenback’s moves against six major currencies, is up by over 6% in the last ten months on the back of expectations of the US economy doing better than other countries in the developed world. A weak rupee has many implications: it is seen as a signal for FIIs to pull money out of the country’s equity and debt markets, leading to a fall in prices of stocks and bonds; it is inflationary because it increases the government’s fuel and fertiliser subsidy bill and widens the fiscal deficit; it affects monetary policy, too: to stem currency volatility, the RBI sells dollars, which sucks out liquidity from the system, pushing the RBI to bond purchases next. A falling rupee is definitely a cause for concern in the near term. However, in the longer run, will it really matter for domestic asset prices? From 1995, when the economy started opening up, to date, the rupee has fallen 60% against the US dollar. However, equity indices are up six-fold in the same period. Bond yields are down from high double-digit levels seen in the 1990s to single-digit levels. Inflation is also down from high double-digit levels to single-digit levels. The correlation between the rupee and financial markets breaks down at some point, as seen over the longer term. The current weakness in the rupee will affect equity and bond market sentiments on worries of FII outflows. However, FIIs are not likely to take out money in hordes from these levels. Even if they do, they will not get an easy exit. For, as soon as the markets sense FII selling, they will front-run and make exits at low impact costs almost impossible. For example, if FII outflows are expected, speculators will drive down the rupee to 56 per dollar, while the Sensex will be pulled down by 10%. FIIs may not come in aggressively to India on rupee worries, but they will not take out money aggressively either.