The upward move of the rupee against the US dollar was very sharp in the recent weeks as the rupee has climbed about 5.6 percent since the beginning of September due to sustained capital inflows. However, the pace of the move surprised many.
The fund inflows from Foreign Institutional Investors (FIIs), for the calender year so far, have topped a record $24 billion and the rupee is up 4.4 percent. The net FII inflows touched a record USD 8 billion in September alone. First time in this year the central bank 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 IPO pipeline. “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 Reserve Bank of India (RBI) and the US Fed,” says Priyanka Chakravarthy, Forex Strategist of Standard Chartered Bank She expects the value of Rupee to revert to choppy range-trading against he US dollar into year-end,
The speed and volume of current inflows have caught the market by surprise. In September, Indian markets recorded an average net daily inflows rose to USD 401million from USD 160 million June-August 2010.
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 relative to other major Asian markets.
Foreign inflows into bonds may pick up due to the recent relaxation of the FII investment limit for government and corporate bonds to USD 10 billion and USD 20 billion, respectively. However, Standard Chartered Bank expects the maximum impact of this to be the additional investment of USD 5billion n 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 USD 32 billion in the financial year ending March 2011. Of this, USD 24 billion had already flowed in as of 13 October 2010.
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 is likely to be modest, compared to its earlier expectations. We now expect the FY11 trade deficit to widen to USD 146bn, from USD 138bn prior. 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 USD-INR range-trading.
The recent rupee appreciation for the last few weeks again put the exporters into enormous trouble, says S. Dhananjayan, Financial Advisor, Forex Derivatives Consumer Forum, Tirupuar. According to him, exporters are finding it extremely difficult to cope up with such wide and short term fluctuations in USD-INR exchange rate due to heavy competition between other competing countries and the less favourable status for Indian Exports as compared to say Bangladesh due to their Most Favoured Nation Status with US and EU.
As seen in the year 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 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, similar scenario in 2007 was grossly misused by banks who acted as cat’s paw for their US counterparts thereby selling illegal derivative contracts to gullible exporters across the country thereby causing havoc to the economy.
"We’ve seen the rupee go from 52 to 39 and back and forth,” V. Balakrishnan, Infosys Chief Financial Officer told reporters earlier 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.” Infosys said it suffers a 40-basis point drop in operating margin for every 1 percent movement in the rupee. The rupee has gained about 15 percent 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's 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.”
Strauss-Kahn noted that while the capital flooding into fast-growing China and other Asian countries can spur growth, it could also fuel excessive lending, asset price bubbles and financial instability, In some cases, controls on capital may 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 earlier this month there was no need to curb foreign investment. “I do not think that situation has arisen in the Indian economy today,” Mukherjee said. At the same time, he said 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.”
China is in no mood to appreciate Chinese yuan. Yi Gang, vice governor of the People's Bank of China, reportedly stated that the country is 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.
