The upward movement of the rupee against the U.S. dollar was sharp in recent weeks as the Indian currency has climbed about 5.6 per cent since the beginning of September due to sustained capital inflows. However, the pace of the move surprised many.
Inflows from foreign institutional investors (FIIs) so far in the calendar year have topped a record $24 billion and the rupee is up 4.4 per cent. In September alone, net FII inflows touched a record $8 billion. For the first time in this year, the Reserve Bank of India intervened and bought dollars from the market to cool the rupee appreciation.
The sharp pick-up in daily inflows has largely been due to the impressive initial public offers in the primary market. “This suggests that a slowdown may be in the offing once the major IPOs are completed and the focus shifts to the impending monetary policy meetings of the RBI and the U.S. Fed,” says Priyanka Chakravarthy, Forex Strategist of Standard Chartered Bank. She expects the value of the rupee to revert to choppy range-trading against the greenback into year-end.
The speed and the volume of current inflows have caught the market by surprise.
In September, Indian markets recorded average net daily inflows of $401 million against $160 million during June-August.
India's capital account outlook remains optimistic, but some market watchers feel that the current pace of equity FII inflows may not be sustainable. Once the major IPOs are completed, valuations may come into investor focus, leading to a lull in equity inflows. According to the price/earnings ratio, Ms. Chakravarthy believes that Indian equities now appear overvalued, not only by historical standards but also by other major Asian markets.
Foreign inflows into bonds may pick up due to the recent relaxation of the FII investment limit in government and corporate bonds to $10 billion and $20 billion, respectively. However, Standard Chartered Bank expects the maximum impact of this relaxation to be the additional investment of $5 billion allowed for government bonds. Anecdotal evidence suggests that for corporate bonds, even the earlier limits were not completely utilised. As such, it expects FII inflows into debt and equity to total $32 billion in the financial year ending March 2011. Of this, $24 billion had already flowed in as of October 13.
Exporters in trouble
India's large trade deficit also remains an important focus. Standard Chartered Bank said that an improvement in the trade balance in the coming months was likely to be modest, compared to its earlier expectations. “We now expect the trade deficit to widen to $146 billion 2010-11 from $138 billion previously. Thus, the monthly trade deficit is likely to stay in double digits.
In such a scenario, a slowdown in capital inflows may result in a renewed focus on deficit financing risks, leading to another episode of dollar-rupee range-trading,'' the bank said.
The rupee appreciation in the last few weeks again put exporters into enormous trouble, says S. Dhananjayan, Financial Advisor, Forex Derivatives Consumer Forum, Tirupur. According to him, exporters are finding it extremely difficult to cope with such wide and short-term fluctuations in the dollar-rupee exchange rate due to heavy competition among other competing countries and the less favourable status for Indian exports as compared to, say, Bangladesh due to its most favoured nation status with the U.S. and the EU.
As seen in 2007-08, the rupee appreciation is caused mainly due to FII inflows into the capital market in India. Mr. Dhananjayan warns that these inflows are purely speculative and hedge fund money which are intended to jack up the indices and the FIIs would quit instantaneously as and when they decide to book profits. “This kind of uncontrolled capital flows that artificially creates volatility in the currency market is unhealthy for the real economy.” According to him, a similar scenario in 2007 was grossly misused by banks which acted as cat's paw for their U.S. counterparts, thereby, selling illegal derivative contracts to gullible exporters across the country. “We've seen the rupee go from 52 to 39 and back and forth,” V. Balakrishnan, Infosys Chief Financial Officer told reporters early this month. “It will kill the whole export industry. The RBI has no choice but to intervene at some point in time, like every other country,” he said. It was also reported that Infosys suffers a 40-basis point drop in operating margin for every one per cent movement in the rupee.
The rupee has gained about 15 per cent since it slid to a record low of 52.185 in March 2009. It had strengthened past 39 on January 15, 2008.
The International Monetary Fund (IMF) chief recently asserted the need for better control over capital flows. While meeting central bankers, IMF Managing Director Dominique Strauss-Kahn said, “Asia is leading the global recovery and is moving swiftly back toward normal policy conditions. Capital flows are flooding in. We do not want history to repeat itself in such a short time span.” Mr. Kahn noted that while the capital flooding into fast-growing China and other Asian countries could spur growth, it could also fuel excessive lending, asset price bubbles and financial instability.
In some cases, controls on capital might be justified to stem such risks, he said.
But India and China are unlikely to heed this. After the rupee rose to a two-year high against the dollar, Finance Minster Pranab Mukherjee told reporters in Washington early this month that there was no need to curb foreign investment. “I do not think that the situation has arisen in the Indian economy today,” said Mr. Mukherjee. It is the responsibility of the central bank of every country to watch inflows that may make it vulnerable to currency appreciation, and intervene as and when it is necessary, he said.
China is in no mood to appreciate the yuan. Yi Gang, Vice Governor of the People's Bank of China, reportedly stated that the country was resolved to push ahead with cautious reforms of its own currency regime. This statement, critics believe, is the strategy of keeping the Chinese yuan artificially undervalued, making the country's exports cheaper in overseas markets and contributing to huge imbalances in trade.
OOMMEN A. NINAN
Market watchers feel that the current pace of equity FII inflows may not be sustainable