Rupee faces multiple headwinds :: Business Line

Please Share:: India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��

There will be pressure on the rupee unless steps are taken to fix structural issues. The government and the Reserve Bank of India are well aware of this risk.

The dollar-rupee rate has a significant impact on not only the fortunes of individual firms and sectors, but also the government.

While this exchange rate has been by and large stable for the last five years, there have been periods of significant volatility. For instance, this rate moved from 40 to 51.50 from March 2008 to March 2009. We believe there is a significant downside risk to USD-INR exchange rate.

RISKS TO THE RUPEE

Inflation is at an all-time high; the consumer price index (CPI) increased 10.88 per cent in 2009 and 13.19 per cent in 2010. The monetary policy changes to control inflation have been ineffective.

We believe this is because inflation is being driven primarily by structural supply side challenges and lack of import buffer for staples such as pulses where India is one of the main producers worldwide.

India has witnessed a decline in foreign direct investments (FDI) in 2010, making it the only BRIC country where this happened. This is troubling as FDI is an important indicator of investors' faith in a country's long-term prospects.

Foreign institutional investment (FII), which provides short-term portfolio investment money inflows, has been buoyant, but these funds are volatile by nature and are prone to “flight risk”, something that happened during the financial crisis.

Recent widespread corruption scandals have reinforced the negative perception of governance deficit in India. This, combined with regulatory and tax uncertainty, will deter foreign investors. A major source of foreign currency inflows to India is remittances; India received $55 billion in remittances during 2010. West Asia accounts for a major share of this inflow and the current turmoil in the region may negatively influence it.

DEFICITS

The combined Central and state government deficits have stubbornly stayed around 10 per cent of GDP. Another major concern is that India imports about 70 per cent of its oil and efforts to increase the production capacity of petroleum and natural gas domestically have not been very successful.

India's current account deficit is about 3 per cent, the level it reached during the crisis of the 1990s.

A current account deficit is not bad by itself for a growing economy if it helps build important long-term productive assets. Unfortunately, some of this money already seems to be feeding speculative real estate activity instead.

The United States economy seems to be on the path to recovery. It is very likely that the improving US economy will draw more funds at the expense of emerging countries. This can already be seen in the FDI inflows, which increased by 43 per cent in 2010.

THREE SCENARIOS

After studying the various demand and supply factors for the rupee, we have arrived at three likely scenarios:

The first scenario is rupee depreciation. This scenario is likely to occur if oil prices continue to rise or if FII money “exits” because of a crisis of confidence. Based on past evidence, even a relatively orderly outflow of $15 billion of FII money over a year could result in the rupee depreciating by 22–30 per cent.

This would imply an exchange rate in the range of Rs55–60 to the dollar. It could get even worse if the flight of capital were to take place over a shorter period.

This would imply a higher cost of petrol, diesel, and petroleum products in India, leading to even higher food prices and Consumer Price Index. The current account deficit would balloon and the rising inflation could create a vicious cycle.

The second scenario is rupee appreciation. This scenario is likely to occur if the FII money continues to flow in and FDI levels improve. An appreciating rupee will make imports cheaper and lead to better managed deficits and inflation.

The third scenario of status quo is the most benign one. The exchange rate continues to move in its current range and slowly appreciates over the long term as the economy continues to develop and India strengthens its position in the global markets.

The government's efforts to improve agricultural infrastructure bear fruit in the longer term and inflation declines. Exchange rate fluctuations do not cause any major disruption in the trade environment.

PRESSURE ON RUPEE

According to our analysis, during the next two years the probability of the first scenario (depreciation of the rupee by 20 per cent) is the highest (about 50 per cent) while the other two scenarios have an equal probability of approximately 25 per cent each. In other words, there will be pressure on the rupee unless steps are taken to fix structural issues described in this article.

The Indian government and the Reserve Bank of India (RBI) are well aware of this risk and are definitely hoping for the third scenario, in which India essentially grows its way out of trouble over a couple of decades and where they only have to intervene occasionally to smoothen out excess volatility.

As Dr Subir Gokarn, a deputy governor of the RBI recently said, “Intervention is not costless; it simply transfers the cost from one constituency of the economy to another.”