The rupee at 80 may be transient if one goes by recent history. Every time the rupee has crossed this mark there has been intervention to steady the volatility. The currency market today is being driven by one overwhelming feature – the dollar-euro relation – which has tended to put relentless pressure on all currencies. The US Federal Reserve has increased rates by 75 bps and the indication is that the rate will go past 4 per cent to 4.4 per cent by the end of the year. This means that the dollar will continue to strengthen and collateral effects will be felt on other currencies.
The rupee is already being pressured by the widening Current Account Deficit (CAD). It can go up to 3-3.5 per cent for the year. The reason is not hard to guess. The trade account is widening fast as exports growth is now moving closer to the negative zone with the global economy slowing. Imports are rising as India is still a fast growing economy at around 7 per cent. What is comforting is that commodity prices are moving southwards which is good for the trade deficit. But with the deficit widening, there is pressure on CAD. Add to this the invisibles account, which tends to slow down when parts of the world move into a recession as remittances and software receipts take a backseat, and we can expect pressure on the CAD.
At present there is quite a bit of support coming from capital flows, especially FPIs, which have been buoyant and have provided cover for the current account. In fact, the Indian stock market has also tended to be more buoyant and in a way resilient to these developments relative to the western ones. But for sure, volatility in these flows will affect the net inflows, especially in the equity segment.
The Reserve Bank of India (RBI) on its part, has played a critical role in managing the rupee. There have been overt sales in the market as evidenced by the decline in forex reserves. Action taken in the forwards market of around $19 bn by July and about $36 bn in the spot (which would have increased in August) has helped stabilise the rupee. The policy changes announced in liberalisation of the capital account for FDI, NRI and ECB accounts would work over a period of time and may not in the short run deliver the support for the balance of payments.
Therefore, looking ahead, the two critical factors would be how the dollar-euro relation works out, which at present, looks heavily tilted towards further appreciation in the medium term. But one must realise that the sudden fall today is more an immediate response to the Fed move which was not different from what the market expected. Hence there is reason to believe that the rupee will be back to the 79.5-80 mark soon.
The critical part in the forex market is, however, the reaction of the RBI. Any intervention through spot or forwards transactions, or even indirect nudging through the NDF market will allay fears of the market. Curiously, no action from the RBI will be interpreted as the central bank being happy with the depreciation, which in turn would become self-fulfilling. Exports will hold back their earnings, while importers will rush to buy dollars thus spiking up the rate.
Hence, a lot will hinge on RBI action in next two days as it will set the tone for market behaviour. The rupee has been one of the best performing currencies and the RBI will be setting the goal post by its actions. If it sits back, the 81 mark will then be tested. That’s how the market will work.
Madan Sabnavis is the Chief Economist at Bank of Baroda, and author of – Lockdown or economic destruction. Views are personal.