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Economy Nov 25, 2011

Should RBI help to prop up the rupee?

By Madan Sabnavis

Amid the brouhaha surrounding inflation and an industrial slowdown, the new joker in the pack appears to be the exchange rate.

A falling rupee has been on the news sidelines for a while, but given that it has crossed the 50 mark, concern is palpable.

Memories are still fresh of the times when the rupee was appreciating and we were wondering what should be done.Now, it is quite the reverse as we rack our minds on how to tackle a rapidly depreciating rupee.

Let us first try and figure out why the rupee is falling quite steadily.

What's causing the rupee to plunge?

There are two sets of factors behind this phenomenon.The first is extraneous and the other is internal to our system.One way to interpret this is that the external factor sort of triggered the rupee's fall and was reinforced by internal conditions.

Rupee

Why is the rupee falling steadily? Pawan Kumar/Reuters

Externally, the rupee is driven significantly by the dollar-euro relationship.A stronger dollar vis--vis the euro automatically weakens the rupee.That is what happened in the last month or so when the euro crisis resurfaced with Italy also joining the gang of erring countries.

That helped to strengthen the dollar, which, if one recollects, took a beating in August when the world spoke of a US debt default.Things have changed quite drastically recently with the dollar chugging along, leading to a weakening of other currencies.

But, this should have happened in other nations too, which was not the case. This is where the internal factors matter.

The balance of payments offers some clues

Exports grew quite aggressively to begin with, but have slowed down in the past two months, thus exacerbating the trade balance.

Software services, which have helped our invisibles account, have slowed down ostensibly due to the global economic slowdown. That has pushed up the current account deficit. In the past relief has been provided by the capital account which has sort of let us down now.

While FDI (foreign direct investment) has been strong, the critical factor, i.e., foreign institutional investor flows have slowed down this financial year, and have not been compensated by other inflows.

External commercial borrowings (ECB) have been buoyant, but again, not good enough to make up for the slowdown in foreign institutional investment.

The result has been a decline in reserves and a fall in the rupee.

In all markets, sentiment plays a role, and now this factor has taken over.Importers are panicky as they have to pay more rupees and are buying up dollars.Further, we have around $23 billion of debt servicing this year.

Intuitively, one can see that with a one-rupee fall in the exchange rate, the additional cost would be Rs 2,300 crore to these debtors.

Therefore, there is greater demand for dollars which, in turn, hastens the fall of the rupee. A falling rupee also dissuades ECB borrowings as borrowers weigh the exchange rate risk and cost against the advantage of lower global interest rates. Hence, sentiment is hitting the rupee from all sides.

Can anything be done?

There is an option of hedging the forex risk given that we have a fairly vibrant forex derivative market.At least all those who have immediate exposures in the next six months can take forex cover through such markets.

Longer-term exposure is, of course, not possible in India unless one has access to global markets for hedging. One should go long in these markets and offset at a higher rate to cover for losses.

The other option is that of Reserve Bank of India's intervention. Here again there are two possibilities.The first is for direct intervention by the RBI under which it supplies dollars in the market to cool it.

This cannot, however, be a continuous process as there can be no end to it otherwise.For this, one has to figure out what is the RBI's comfort level.

While importers and debtors are being impacted, exporters would be better off with higher returns, though arguably, they might not be able to gain much in a state in which global economic growth is sluggish.

The other route can be for the RBI to make strong statements, because once the RBI starts to communicate, it can bring the market back in order to the extent that it is driven by sentiment. The fundamentals, however, cannot be changed by the RBI except through actual intervention.

The RBI's view presently appears to be that forex reserves have been created by capital inflows and hence, cannot be used to take care of current account issues.

While this is true to an extent, the exchange rate is also being driven by capital account considerations and hence, it may not be too improper for the government to intervene right now.

We certainly do need action from both the corporates (through hedging) and the RBI, through some affirmative statement or else there will be a lot of mark-to-market losses that will have to be booked by the corporate sector.

Corporate profits are already under pressure from inflation, slower demand, higher interest rates and now, exchange rate losses.

The current depreciation of around 13 percent since April has more or less negated all the benefits of declining commodity prices globally, which would have, otherwise, had a soothing effect on domestic inflation.

Hence, the RBI has now to open a second window to tackle currency movements even as it tackles the other issues of inflation and monetary policy.

Madan Sabnavis is chief economist at Care Ratings. The views are personal.

by Madan Sabnavis

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