Back in 2008, rumours about a surge in Asian demand sent crude oil prices soaring by nearly $30 a barrel between April and July. In India, as oil importers scurried to source dollars to continue importing the precious commodity, the rupee weakened, depreciating to 42.49 to the dollar by the end of July from 39.90 at the start of April.
A similar upsurge in international oil prices has accompanied the political upheaval in West Asia since the beginning of this year. The unrest in Libya and Bahrain has pushed up the price of Brent crude by nearly $30 a barrel since November 2010 to around $122, similar to the levels in May 2008.
Not a repeat
But there has been no concomitant weakening of the Indian currency this time. In fact, over the past six months, the rupee has moved in a narrow band of 44 to 45.9 to a dollar. It was at 44.30 when this issue was going to press. What's more, experts do not see the value of the rupee, which is determined by sentiment in the foreign exchange market and the supply and demand for dollars in the economy, declining sharply. "The rupee's strength is slightly out of tune with what the foreign exchange market's reaction should be to high oil prices," says Hemant Mishr, Head, Global Markets at Standard Chartered Bank. "I don't expect a dramatic decline of the rupee."
The rupee's strength is slightly out of tune with what the market reaction should be to high oil prices. I don't expect a dramatic decline of the rupee: Hemant Mishr, Head, Global Markets, Standard Chartered Bank
The relative stability of the rupee is the only good news in an otherwise stressed macro-economic scenario. Inflation
accelerated in March at a rate of just under 9 per cent, more than the Reserve Bank of India had projected, as the costs of fuel and manufactured goods rose. The government's failure to address supplyside constraints in a timely manner has kept inflation persistently high and forced the central bank to raise interest rates eight times since early 2010. High borrowing costs showed up as a worry in the first Business Today-C fore Business Confidence Survey conducted in March (Why Business Loves Inflation
, BT May 1, 2011, also on www.businesstoday.in/BCI). A run on the rupee in such a situation, given the economy's high oil intensity, could take a couple of percentage points off the growth rate. But that risk has yet to materialise.
What has created the strong outlook for the rupee? Several factors, according to experts. For one, traders in the foreign exchange market believe that the recent oil supply problems are localised in nature and scope. In 2008, a surge in Asian demand was perceived to be a bigger crisis as it would have drastically altered the supply-demand and pricing equations over the long term. In contrast, the current crisis is confined to a few countries and has yet to touch powerhouse suppliers like Saudi Arabia and Iran. World oil production figures remain high. "The jury is still out on whether the oil price hike is sustainable," says Harihar Krishnamurthy, Head of Treasury at Credit Development Bank.Dollar to the rescue
The rupee has also been buoyed by a persistently weak US dollar, a trend that analysts predict will continue through 2011 as the world's largest economy struggles to resolve the problem of a near-crippling fiscal deficit. "One of the major reasons for the strong rupee is the weak dollar. On a real, effective exchange rate basis, the dollar has lost sharply against the Euro and the rupee as well," says Mishr.
Foreign institutional investors, or FIIs, have been bringing a steady stream of dollar investments into Dalal Street this year. The slow pace of recovery in developed economies, the unwillingness of the US Federal Reserve to raise interest rates and the recent crisis in Japan have all combined to keep intact India's attractiveness as a destination for foreign investments.
Even though longer-term investments are yet to pick up, FIIs have invested $3.6 billion into Indian equities and debt markets so far this year. This is lower than the $10.3 billion invested during the corresponding period last year but still high enough to provide a steady supply of dollars to meet demand.
In 2008, in contrast, the oil crisis was accompanied by a flight of foreign institutional investments from Indian markets. FIIs had pulled out $9.3 billion from Indian equity and debt markets that year. As long as the supply of dollars continues, the rupee is likely to remain stable.
"Sustained easy liquidity in the United States and Japan means more and more money in emerging markets," says Mishr. "India is hand in hand with that." But FII inflows do not always stabilise the rupee. The past year saw the return of foreign investors to Indian equity markets, pumping in $39.4 billion. But the exchange rate remained volatile.
The real calming effect on the rupee comes from a drop in the current account deficit, or CAD, prompted by a surge in exports
. The CAD reflects a country's trade in goods and services and its remittances from abroad. Countries that are net creditors to the world run a surplus, while net debtors run a deficit. For years, India has run a significant CAD due to its high import bill. It was two per cent of the Gross Domestic Product, or GDP, or $9.7 billion, in the quarter ended December 2010, compared to 4.1 per cent of GDP in the quarter before that ($16.8 billion). A persistent CAD weighs on the rupee as the country has to finance its debt ultimately.
But exports are on the rise. Exports rose by 37.1 per cent to $245.9 billion for the 2010/2011 fiscal year, far above a projected $200 billion. "If exports take off, it lends more strength to the rupee than investor money coming into the debt or equity market," says Krishnamurthy.
The rupee also owes its strength to India's comfortable $300-billion foreign exchange reserves as well as the fact that the country's imports are mostly inputs for its manufacturing sector and not consumer products, all of which reduces somewhat the vulnerability of the Indian economy and, therefore, of the rupee to the global oil price situation, says Krishnamurthy.
So, has the rupee developed immunity to global shocks? Not yet, say experts. The current scenario presents a happy confluence of positive factors, but a sudden change in any of them - a movement by FIIs towards other markets, for example - could trigger a run on the rupee. For long-term strength of the rupee, the nation will have to make significant changes in its export portfolio, which has historically relied on software services.
"It is a question of how long we can rely on services and information technology alone," says B.L. Pandit, the RBI Chair Professor at the Indian Council for Research on International Economic Relations, or ICRIER. Rising exports to new markets like Latin America, where India is looking at trade agreements with nations like Chile, is good news. A rise in manufacturing and engineering exports will also buffer the rupee in the long term.
"We're seeing good tentative signs on the trade deficit side but it is too early to say if these are structural gains that can be forecasted into the future," says Mishr. He adds that if India wants to become more resistant to oil price shocks, it will have to invest more seriously in alternative forms of energy and energy independence.
If oil prices continue to rise, Krishnamurthy says they could drag the rupee down, as crude importers look to buy dollars to supply a nation that imports nearly 75 per cent of its energy requirements and has traditionally been viewed as very susceptible to volatility in global oil prices. But an exchange rate shift like the one in 2008 remains an unlikely possibility for now.