The Indian Rupee Fundamentally Weak, Shaking Off Postive FII Sentiment (SAY, WIT, INFY, GLD)

The Indian Rupee (INR) is down over 2% this month and 1.5% just this week. What is driving the rupee down? The Rupee is fundamentally weak, but has been propped up by overly positive sentiments of Foreign Institutional Investors (FIIs), which are now moderating, writes Mumbai-based investment pro, and frequent contributor to IndiaStockBlog, Gerard Pascal. The fundamental reasons for the rupee to continue weakening are still in place, he says, while the sentimental reasons that have been propping the rupee seem to be fast disappearing, especially with foreign brokerage houses predicting a correction of the Indian equity markets. He briefly comments on the impact on the Indian outsourcing sector: Infosys (INFY), Satyam (SAY), and Wipro (WIT).

Factors weighing on the Rupee:

• Trade and Current Account Deficit On the surface it would appear that oil would be the cause of the widening trade deficit. But non-oil imports are growing faster than oil imports. The largest growth in imports is... gold! (Related: The Gold Stock Blog, When Will India Kick Its $200 Bln Gold Habit?)
• Fickle Financing Financing is largely being driven by fickle sources such as External Commercial Borrowings (ECBs), Non-Resident Indian deposits (where carry trades are getting wiped out every day, with the Federal Reserve likely to up the U.S. fed funds rate at the next two meetings). The volatile FII inflows are unlikely to continue at the soarching pace they have set so far this calendar year
• REER Overvalued The rupee is overvalued on the trade weighted index, even if you take into account China and Hong Kong in the new REER index that the Reserve Bank of India (RBI) -- India's central bank -- is constructing
• The Rupee is Quasi Dollar Pegged Despite denials by the RBI, the rupee is pegged to the dollar unofficially. The dollar has strengthened significantly since May (as measured by the dollar index); so the rupee had to weaken.
• Withdrawal Pressures in December In December, the 5 year IMD deposits of US $ 5 bn issued by SBI are due for redemption; this will put pressure on the rupee.

The Rupee this week

Noteworthy during this recent slide by the Indian rupee was the lack of intervention by India's central bank. Only on Tuesday it appeared to intervene, to prevent the rupee crossing the psychological level of 45 (with respect to the dollar). In addition to the lack of intervention from the central bank to prevent the wild swings in the rupee, there is an INR 0.10 arbitrage between the onshore and offshore forward market, which is weighing down the rupee.

Equity Impact

The Indian software outsourcing sector loves a depreciating rupee, as its earnings to a large extent are denominated in U.S. dollars. Infosys (INFY), Satayam (SAY) and Wipro (WIT) stand to benefit from a weak Rupee.

Comments

[User 1:]

Unfortunately, there is no straight answer to your question. For an economy with completely open capital accounts and a freely floating exchange rate, it is enough to look at current account deficits to reach a judgement about whether the currency is going to appreciate or depreciate. In the medium to long run, mind you. In the short run, things like capital flows will be the main drivers of exchange rate movements. The problem in arriving at a judgement about the rupee is the following : India has only a partially open capital account. Consequently, the RBI can do independent monetary policy while also targeting the real exchange rate which is what it did through much of the 90s, allowing the nominal exchange rate to depreciate steadily since India had relatively higher inflation rates. In such an environment, it is really difficult to pin down any kind of equilibrium real exchange rate, relative to which judgements can be made(I suppose it can be done, but its not an easy back-of-the-envelope calculation, and I would not trust the Big Mac index too much in guiding my hand). You have outlined 5 factors weighing on the rupee. In the short run (one or two quarters ahead), I would argue that factors 2 and 5 would drive market valuations of the rupee. But a central bank which can would typically try to smoothen these fluctuations out, so I expect the RBI to intervene if these factors create too much volatility in the rupee’s value, and so you would need to take into account the RBI’s reaction function to arrive at a judgement about the direction of the rupee. Do we know what the RBI’s reaction function is? No. In the long run, where is the rupee going? I really have no clue.

2005 Oct 16 05:26 PM

[User 1:]

Hi,

Two more factors to be kept in mind is the interest rate differential as well as growth in export (besides the exporters lobby for weaker rupee).

Rupee has already touched the 10 1/2 month low and if the FII money keeps pouring into the stock market as it has in last 9 months of 2005, then we might see some stability.

RBI may not be keen to intervene as the interest rates as well the inflation are under control, hence their policy would be restricted to reducing the volatility of the Rupee. Besides with the introduction of Rupee options, the depth in the Rupee market has increased manifold.

signing off…

2005 Oct 16 05:28 PM

[User 1:]

Prince,

Actually, interest rate differentials will not be very helpful, since capital controls introduce a wedge in the interest parity condition, and this wedge depends on the RBI’s reaction function. Rather (and contra to the last sentence in my earlier comment), productivity differentials between India and her prominent trading partners will be more informative about where the rupee is headed in the long run. Countries with higher productivity typically have more appreciated exchange rates.

Deep

2005 Oct 16 05:29 PM

[User 1:]

i had been going through this recently during some research ( www.cia.gov/cia/public... and also www.cia.gov/cia/public... )and i think this holds the key to a fresh look at your question. To look at some of the factors that normally impact exchange rates:

1. The current account deficit of the US is $ 680 Billion . India’s is a + balance of $4.87 Billion

2. Trade
US Total exports and imports - $650 Billion and $1.4 Trillion
India Total exports and imports - $69 Billion and $89 Billion

More relevant the trade balance between India and US
Exports - Imports= $12 Billion - $5.4 Billion is $6.6 Billion in India’s favour

3. Interest rates: India’s interest rates have climbed down by over 1000 points in 10 years (1995-2004)While I do not have the comparable rate for USA I am sure there is no comparison. It still remains between 3-4% over the USA, making it attractive to buy rupees. the fear of inflation is also down.

4.Foreign exchange reserves of the USA including gold (official) is $86 Billion
India’s is about $ 126 Billion
If india sells dollars, ( of which it has no great need) rupee would have to appreciate

5. External debt as a percentage of GDP (PPP)
for USA - is 12%
for India - is less than 4%
at some time or other soon the USA has a debt trap to worry about. India doesn’t

note:
1.FDI flow in India is negligible ( $5 Billion)and has only decorative effect on indices

2. Gold , while nominally a dead investment is actually a strong and vibrant financial instrument ( ask pawn brokers) India’s undeclared assets in gold should be of the order of $2.5 - 5.0 Trillion

while this merits a more rigorous analysis, basic takeaway should be that the unofficial pegging of the rupee to the dollar ( done by indian government)is wrong. the moment it is removed, there is no doubt that the rupee should appreciate.

2005 Oct 16 05:31 PM