The steep downward movement in the rupee?s exchange rate over the past month has created a big scare all around and may have undermined the confidence of potential investors, both foreign and domestic, in ways that we are yet to understand. The rupee has depreciated about 26% year to date, and the steepest decline was seen over the past few weeks as the exchange rate breached the R56 to a dollar mark. From here on, it seems like open season on the rupee as banks and brokerages are loosely talking about R60 to a dollar with a sense of inevitability. This is the real damage done to the underlying confidence in India?s economy. The overall perception that nobody is really firmly ?in charge? at the political and policy level to communicate properly with investors is undermining confidence further. It is as if Murphy?s law has taken over and everything that can go wrong is indeed going wrong.

The confidence of investors is shaken for several reasons. For instance, it was in last October-November that the rupee went through a first round of a major shake-out. Due to the massive current account deficit?about 4.3% of GDP?in the October-December quarter, coupled with virtually zero FII inflows, there was indeed a huge scare about an impending balance of payments (BoP) problem. However, those fears were somewhat belied as investors reposed fresh faith in India and continued to pump in money. After that episode, RBI made NRI deposits more attractive as a means to attract additional dollar flows. Some big-ticket foreign investment flows, such as British Petroleum?s investment in RIL, had boosted overall FDI flows to about $50 billion in 2011-12. At the beginning of 2012, even the FIIs returned to the Indian market in a big way and pumped in about $8.5 billion between January and March. In this quarter, India received the second highest FII inflows among all Asian economies. Only South Korea got a little more than India.

The short point one is making is that India managed to win back global investor confidence after the October-November BoP scare when the currency seemed like it would go into a free fall. In a way, the faith in India?s fundamentals was reinforced until some of the mindless budget proposals negated a lot of the positive effect this March.

Mind you, all these investors, whether the NRIs who brought in fresh deposits since last December under the special dispensation created by RBI or the FIIs who had brought in an additional $8 billion in the January-March quarter, would have come in at an exchange rate of about R50 to a dollar. These investors have already lost over 10% of their investment in just a few months. This would shake their faith somewhat. It will also impact potential investors.

Investors are very confused about what RBI thinks is an appropriate exchange rate based on fundamentals, inflation differentials and so on. There is poor communication in this regard. Unless the investor has a reasonable idea as to when RBI will step in to defend the currency in a thin market such as ours, this confusion will get further compounded. For instance, it will be disastrous if investors develop a new mindset that a safe exchange rate to enter India is R60 to a dollar because so far RBI does not seem unduly worried about defending the currency. That would become a self-fulfilling prophesy and all classes of foreign investors will wait for the exchange rate to touch R60 to a dollar before bringing in fresh investments. That will indeed ensure that the exchange rate does touch R60.

The government and RBI need to avoid this trap. The Chairman of the Prime Minister?s Advisory Council, Dr Rangarajan, has been constantly communicating on the exchange rate in the past two weeks. About a week ago he said RBI should not allow temporary ebbs in the capital flows to unduly impact the exchange rate. That gave the impression that RBI would defend the currency by selling dollars in the market. Indeed, RBI did sell dollars in the market on several occasions to counter the speculators. However, the expectation was that RBI will come down with a sledgehammer if the exchange rate weakened beyond R54-55. Those levels have got breached now, creating a further scare in the market. Some feel RBI has been a bit half-hearted.

One school of thought is that an undervalued currency will make India more competitive and bring in fresh investments. This logic may be theoretically valid but a steep fall in the value of the currency works against investors who may have entered India in recent times. Anyway, the most critical thing here is to clearly convey to the global investors as to what RBI thinks is an appropriate exchange rate so that investors can start returning at that level. That confidence needs to be created.

Dr Rangarajan has said certain confidence-building measures cannot be ruled out in the short to medium term. These include making oil companies buy dollars directly from RBI for their crude purchases. Oil companies buy over $100 billion worth of crude in a year. Of course, RBI cannot draw down its reserves that much. Oil companies will keep buying from the market primarily. But selectively, during periods when speculation against the rupee is high, RBI can open the direct window to oil companies. This will surprise currency speculators in the very short run. However, at the aggregate level, the dollar demand-supply dynamics don?t change. There is talk of floating special bonds to attract NRI money, on the lines of Resurgent India Bonds issued by the NDA after the Pokhran nuclear test when sanctions were imposed on India.

Here again, the timing has to be right and RBI needs to convince the NRIs that they are entering at an appropriate exchange rate. The NRIs who invested some months ago are not a very happy lot. Dr Rangarajan has also talked about reviving confidence in domestic mutual funds and other investment instruments so as to discourage savings in gold, which is also adding massively to the current account deficit. Of course, in the medium term, there is no alternative to getting the overall policy environment right to revive business confidence. The exchange rate is a mere manifestation of everything that has gone wrong so far.

mk.venu@expressindia.com