Yet to Emerge from the Haze

Rajesh Chakrabarti   Delhi     Print Edition: February 2012

Rajesh Chakrabarti, Assistant Professor, ISB Hyderabad The rupee has plummeted precipitously in the second half of 2011, by over 20 per cent in five months. The sharp decline is largely driven by FII outflow, which withdrew over Rs 13,000 crore from August through December. This amounted to close to half of the exodus that India witnessed in the second half of 2008 during the global turmoil. Then too, the rupee had dived from below 43 to a dollar to above 50.

So, why are FIIs pulling out?
We must realise that the phenomenon is not unique to India. With the exception of the Japanese yen and the arguably undervalued Chinese renminbi, the dollar has appreciated against virtually every currency in the world in the August-December period.

This includes both advanced and emerging markets alike. The rise has been more marked in emerging markets, generally in double digits, as opposed to advanced countries where it has been around 5 per cent, with the exception of the euro (10 per cent) and the Swiss franc (close to 20 per cent). Naturally this means the rupee has lost ground against most other major currencies as well, all this due to interest rates nearing rock bottom in USA.

Appreciation of the Dollar (Aug-Dec 2011)
What we are seeing is, broadly, a repeat of what happened during the global crisis of 2008-a flight to safety. When the global financial system seems wobbly, investors prefer to weather out the storm in the harbour, meaning the greenback.

This time, the euro crisis is making them jittery and all bets are off on anything other than the dollar. Nobody can fully predict the impact of complete euro disintegration on global markets and so it is rational to get to the shore and weather the storm out.

This means that behavioural theories may make more sense in explaining the mechanics of the rupee than the standard economic models of exchange rate determination.

Another feature that we saw in 2008 seems to be holding strong too. Then, the trouble was primarily in the US, and, somewhat unexpectedly, while emerging markets bled portfolio flows, the dollar soared. This time again, though the epicentre is the euro, emerging markets' currencies are the more relatively battered. As for India, its higher-than-most inflation has contributed to the rupee being pummelled.

Now, will the crashing rupee make the inflation situation worse? Almost certainly yes, with the impact likely to be significant, particularly if the slide continues or the rupee does not recover at least partly. Our imports are now close to 30 per cent of GDP and there is no way the economy can be sheltered from rising costs. Any support to fuel prices will eventually wear off and that will have a significant impact.

So, how does the gains for exporters compare to importers' losses?

At this level, and given the suddenness of the decline, the losses are greater than the gains, and most prominent in the short run. We may hope to see a 'J-curve' effect in the long run, but given our inelastic demand for fuel, the gains may not be that much. The long-term impact is far more uncertain given the unpredictability of the global situation. On the whole, the fall of the rupee to this level and so quickly is bad for the Indian economy.

What's in store in 2012?
Of course, the RBI has already stepped in, perhaps later than it should have, and a bit hesitantly. The problem with a rapid fall in an asset price is that it spawns expectations of a further fall and so damage control is harder in the later stages.

It is unlikely that FII flows will turn around significantly before the Greece issue (and other Euro issues) is resolved, which is at least a few months away. By that time India's growth and inflation projections will begin to count. As of now, it is not particularly uplifting.

ALL ABOUT THE RUPEE

Overall, 2012 has arrived with a significant cloud cover. But exporters cannot complain about the level of the rupee, though choppiness is bad for everybody.

Investors would do better to focus on foreign transactions of companies and analyse the currency exposure of firms more carefully. Companies with Foreign Currency Convertible Bonds (FCCBs) are already facing defaults.

Some off-the-book currency products that banks sell to companies may actually make matters worse. Insisting on disclosure of such deals and careful consideration of currency risks is essential for good investing. Risks emanating from dollar-denominated financing need to be factored in.

For companies that are relatively more India-centric, exposure to commodities need to be considered. Dollar-priced commodities may increase costs and corporate results are unlikely to brighten the picture, at least during the first half of the year.

On the bright side, some exporters may witness gains in offshore markets. Textile, leather and other export-oriented sectors are particularly likely to gain.

Keep in mind to check if gains from nominal depreciation are marred by cost rise through higher inflation. Ultimately, gains would depend upon changes in real exchange rates. Also, it would depend not just on the sliding rupee but how the rupee fares compared with competing countries in relation to the dollar.

The author is Assistant Professor, Finance, at the Indian School of Business, Hyderabad.

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