What a difference does just one year make! In August-September 2013, the rupee was in the midst of a mini-run on the currency and now investors often refer to it as a ?boring? currency! Not only has the rupee appreciated by more than 10% over this period but volatility in exchange rate has also collapsed to almost one-fifth of what it was. A combination of factors have helped in making this transition?macro-stability parameters have improved with the twin deficit coming under control, inflation trending down and some green-shoots of a growth-recovery. A decisive election outcome has removed the tail-risk of a political stalemate.

With both macro- and political-stability coming back, India has become the preferred destination of portfolio investment flows. In the past one year, portfolio investment into debt and equity markets have been close to $38 billion, one of the highest in a one-year period; $22 billion has come into the equity market while the rest has been into debt. The pattern has changed somewhat after the election results in mid-May?bond inflows ($13.5 billion) have exceeded the equity inflows ($7.5 billion). With the BoP turning from deficit to surplus, RBI has been able to increase its FX reserves (adjusted for forward positions) from a low of $266 billion to close to $330 billion now?an additional 1.5 months of import cover.

One of the most significant achievements of RBI under Governor Raghuram Rajan has been the stability provided to the exchange rate. The market has become comfortable about the rupee staying in a 60?62-to-the-dollar range. The big question is: Which way will this range break? Let us try to analyse here the factors which can push the currency outside this range, starting with the possibility of further rupee appreciation.

It is quite obvious that a persistent BoP surplus would have led to a sharper currency appreciation if RBI had not intervened strongly. How long can RBI intervene? In our view, RBI?s intervention strategy is likely to revolve around 3 parameters?reserve adequacy, cost of sterilisation and valuation of the rupee. Governor Rajan has often talked about building up a war-chest of reserves as a defence against possible outflows from emerging economies when the US Fed starts hiking rates. Although all the traditional reserve adequacy measures (months of import cover, short-term external debt to FX reserves and volatile capital flows to FX reserves) have improved in the recent past, they are still a long way off from their historic highs. So, RBI?s appetite for more reserves might not get satiated soon.

We have estimated that in a year, around $30 billion of intervention can remain unsterilised to satisfy the funding needs of the economy. Any dollar-buying beyond that is likely to be inflationary and, hence, the need for sterilisation. Initially, RBI has used a sell-buy swap in conjunction with their spot intervention to mop up the rupee liquidity, which was followed by the reverse repo auctions. These sterilisation operations have a quasi-fiscal cost associated with them but we do not think that this cost will become a binding constraint any time soon.

Even from a currency valuation perspective, RBI might not be in a hurry to let the rupee appreciate. According to the 36-country CPI-based REER, the rupee is still about 5.5% overvalued but very close to its historical average. The overvaluation has come down a bit from May and RBI might let that process continue.

RBI?s ability to build up FX reserves will be constrained more by whether India will continue to witness substantial BoP surplus. India?s BoP dynamics will depend on two issues?for how long the trade deficit remains benign and whether we will continue to see capital inflows.

The monthly trade deficit has remained below $12 billion for 16 months and the falling oil prices definitely helps keep the deficit under check. In our view, the current account deficit is likely to stay within the comfort zone of 2% of the GDP which can be funded easily. However, we need to watch out for two things?export growth has dropped to just 2.4% in August from close to 10% average in the preceding 3 months, and non-oil, non-gold imports have grown more than 10% in August (the average for the last 2 years has been 3.5%). This double whammy can pose uncomfortable questions on the trade deficit front. If this trend continues then it might be difficult to relax the restrictions on gold imports too.

The outlook on portfolio inflows also appears to be clouded. High ?carry? and low volatility coupled with expectation of a decline in inflation encouraged debt inflows in the recent past. However, the $25 billion limit on portfolio investment in government bonds has been exhausted and the pace of debt inflows could slow down now. The foreign equity investors continue to remain extremely overweight on India even as the ?cheap valuation? argument loses its shine. If portfolio investments dry up, then the onus of driving the BoP surplus will shift on to FDI inflows.

While the government holds the key to encourage more FDI, a sustained rupee appreciation can happen only when RBI is successful in attaining its ?glide path? inflation target. Inflation differential is the most important medium-term driver of the value of a currency and a narrowing of that might give more comfort to RBI to let the rupee appreciate.

On the other hand, the 60-62 range can break on the upside if the trade deficit starts worsening, there are capital outflows in response to global developments and the inflation differential is not narrowed down. In fact, the near-term trigger for a rupee depreciation can well come from further dollar strength globally. Global risk aversion or expectation of higher US interest rates can both cause the dollar to rally against emerging market (EM) currencies.

Although the rupee could be impacted by EM currency weakness, it is likely to fare better than others. The macro fundamentals of India have improved substantially and RBI has built some capacity to intervene and stem any undue depreciation. In the near-term, what needs to be seen is whether the intervention strategy of RBI will be asymmetric?more intervention when the rupee is appreciating and somewhat less when it is depreciating. Will RBI prefer keeping the ammunition of FX reserves dry for a bigger crisis and let the rupee slide in line with other EM currencies? A relatively neutral Fed has provided a breather for the markets but there is no reason to be complacent.

The author is regional head of research, South Asia Global Research, Standard Chartered Bank