First, a bit on the timelines of the view. Currency markets are the most difficult to predict. Nobody but a technical analyst or a currency trader will dare take a short-term view, and few but an intrepid economist or a George Soros will dare a long-term forecast. In the near-term, the rupees directions will be driven by circumstances that would seem binary. Animal spirits of foreign investors, in the event of a stable party or coalition at the Centre, will handsomely reward India and the rupee in the short-term, with the potential for a sharp and probably relatively brief spurt of appreciation.
After that, multiple factors, most notably macro fundamentals, will shape the direction of the rupee. The first, in current times, of course, is global economics. Overseas investors recently-discovered confidence in Indias potential caused its rapid exit from the erstwhile Fragile Five list. But despite the exuberance, concerns persist. RBI Governor has succinctly presented a formalised argument against the asymmetric balance of influence between advanced and emerging markets, particularly their central banks, on the impact of actions tantamount to a competitive devaluation of the their respective currencies. The result Currency volatility is likely to persist as central banking actions across the globe play out.
Apart from policy actions, there is a strong rationale for the dollar to appreciate. The US economy is improving (despite the poor Q1 growth numbers) and the Fed is likely to complete the QE taper and raise rates much before the Eurozone and Japan. In the world of reduced dollar liquidity and a reduction of arbitrage potential, is India (and other emerging markets) likely to keep getting the quantum of foreign currency funds we have seen in the past few months (or in the heydays before the global financial crisis) Yes, in the event of a stable government, there will probably be a transient spurt (or the reverse, under the alternative).
On the domestic front, drivers of Indias forex inflow and outflows have become more favourable in FY14. The good news is Indias ability to absorb foreign capital has increased, somewhat paradoxically, with a moderation of the CAD, which we had estimated to be in the range of $30-35 billion in FY14, and is likely to go up moderately to $40-45 billion in FY15. Although, the compression in FY14 was mostly due to gold, and is therefore vulnerable to worsening with improving growth, the base scenario remains a CAD which is fairly stable in the short-term, particularly if 2014 global trade improves to 4.7%, as the WTO thinks.
In other words, even a moderate increase in foreign capital flows will result in a balance of payments (BoP) surplus, adding to expectations of a boost to total asset returns based on an appreciating rupee. However, equity markets are increasingly richly valued, and despite expectations of higher forward earnings, the attractiveness of returns on investment will begin to dissipate. Moreover, as QE tapering ends and rates increases are signaled, the global capital pool will shrink and could be re-deployed in advanced economies given their growth prospects. However, a sufficiently large pool of excess reserves remains with global central banks, which can be deployed in attractive assets.
Even with a positive BoP, however, RBI actions in buffering its forex reserves will have implications for the rupee. Overall, foreign currency assets have risen from $248 billion at end-August 2013 to $282 billion by April 18, 2014, a net increase of $34 billion. However, about $4.5 billion of this is estimated to be due to valuation changes, and consequently the net rise in FCA would have been about $30 billion. With opportunistic buying, this might allow RBI to add another $20 billion to its reserves, given the constraint of keeping M0 and M3 growth (the latter already at 14.4%). While we will detail RBIs forex management in another article, this will serve to keep the rupee stable at current levels for some time. Given the need to support the rupee from excessive rise, with an eye on export competitiveness, regulatory controls on channels of capital flows might be a better option, and will probably be incrementally deployed.
Finally, an important question; is the current range of the rupee fairly valued This is one question that defies a definitive answer. The most rough and ready measure is the real effective exchange rate (REER), the trade cousin of the Interest Parity hypothesis. Despite the many known shortcomings afflicting this measure, the rupee seems to be more or less neutral relative to its long-term CPI-based REER average, as the accompanying chart shows. As the reader will observe, however, many interpretations of the REER are possible from different perspectives, with varying interpretation of the appropriate starting point.
What of longer term-prospects A stable political formation, with improved growth prospects would make India an attractive investment prospect. Improving macroeconomic fundamentals will curb excess demand and CAD, but tightening global liquidity will balance capital flows, leading to a more or less stable equilibrium at current levels. However, unless there is a sustained improvement in Indias fundamentals, or if inflation pressures sustain, a weakening bias will gradually emerge once again.
The author is senior vice-president and chief economist, Axis Bank.
Views are personal