How Is The Rupee Riding?

A recent research report from of a US bank reads: As we enter the sixth month of the year, there is ample evidence that the global economic upswing …is taking hold and accelerating… Financial markets and the real economy seem to be once again disconnected, with fin-ancial indicators worldwide reflecting these concerns. The US economy has, in the past two quarters, grown at over 4% and is expected to do likewise in the April-June quarter. The Japanese economy is sho-wing signs of (relatively) strong growth. In our more immediate neighbourhood, Malaysia, Philippines and Sin-gapore have reported robust growth. Corporate earnings have risen to match expectations in most markets, yet uneasiness is the singular quality that seems to permeate the global capital markets.

Expectations of a rate rise have seen yields on US treasuries increase by nearly 100 basis points (bps) on longer terms. Partly in consequence, the US dollar recovered some ground. However, over the past couple of weeks, things have reversed course. US treasury yields have come down some 20 bps and the greenback has lost 4 cents to the euro and also with respect to other major European currencies. Notwithstanding the intervention by the Bank of Japan, the yen too has gained 3% on the dollar. The higher than expected re-cent inflation numbers in the EU have, by raising new questions about interest rate direction in the euro area, further roiled matters. Weaker than expected employment numbers in the US have not altered expectations of rate increases, but has queered the issue of timing and extent.

Crude oil prices at levels of $37 per barrel (UK Brent) in May 2004 were unexpected. The sheer strength of demand, continued non-availability of Iraqi oil and the disinclination of Saudi Arabia to raise output levels to soften the price situation ? all are to an extent surprise developments. Total excess production capacity is estimated at 2.53.5 million barrels per day, just 4% of total world demand, and over half of that is in Saudi Arabia.

It is the popular axiom, though not entirely accurate, that if oil prices stay at these levels, it will hurt the ongoing process of global economic re-covery, and certainly that of emerging markets that depend on imported oil to meet most of their domestic requirements. Even if real effects are subdued, inflationary effects may be pronounced with consequences on monetary and interest rate policy. There is some murkiness as to how the slowdown in China will work out and given the many fortunes that ride on the dragon?s flight, the queasiness factor further rises. Then there is Iraq, where once again the best-laid plans of men have come unstuck. And there is al Qaida, whose ranks, reports have it, have swollen by the thousands.

When uncertainties rise, risks come to the forefront, and markets turn cautious. Since mid-March 2004, non-energy commodity prices have fallen by nearly 10%. Since early-April, world equity prices outside the US have dropped 10% and the emerging market index (MSCI) has fallen by 15%. Indian stock markets have over the past few months seen prices erode by more than 20%. So should one conclude that whatever has happened in our markets is part of a wider phenomenon, over which by definition we had no control? That is certainly not so.

Notwithstanding the developments elsewhere, India had a good chance of beating the trend or, at most, suffer less severely but for the political surprise of the 2004 elections. In a climate of general uncertainty, surprises are the least welcome thing, especially if the movie has a supporting cast of capitalism-bashing politicians in 1960s period costume. The Indian economic story is yet fundamentally sound, its corporates and banks have strong balance sheets and rising earnings, and its external position would have been the envy of all previous finance ministers. Electoral democracy works, government transition is smooth and orderly, the rule of law continues to obtain. The new government stands for much of the same economic policy as the previous one did, with the big exception being privatisation. However, it will yet need to navigate the course, and the obstacles set in place by its Left allies are sufficient to demand great dexterity in the art of navigation.

It is unlikely that the markets in its present global mood will take the optimistic view that the new government will be readily able to rise above the constraints that the political arrangements appear to have placed it in. Even in happier circumstances it is doubtful that capital markets would be so ebullient. The proof of the cake is in the eating and markets would like to see and taste some of the finished product and then see if it tastes good the next day too.

Nobody is rushing for the exit ? for everybody knows what then happens. So expect sustained net selling pressures and little of the opposite. In 2003-04, the capital account had a surplus of $25 billion and the current account a surplus of $5 billion (both my estimates). The current account is unlikely to change very much, but on the capital side they would, and sizeably. External Commercial Borrowings (ECB) are looking at higher asking rates and the gradual disappearance of the one-way bet on the rupee has introduced the overlooked imperative of hedging currency positions. So ECB inflows may not be as buoyant as they have been. Add to that the likely outflow of portfolio investment and NRI deposits. With overall balance of payments surplus in the region of $10 billion, perhaps less, in 2004-05 the RBI will find managing the rupee easy. It will have the liberty of choosing to hold the currency rock-steady by selling down some if its foreign currency assets, or to let the market find its own level with an inevitable downward bias. Inflation at home is expected at over 5%, which will be a clear 250 bps above that in most of the world and should be reflected in exchange rate adjustments. On covered interest parity basis, forward rates should also be reflecting a 2.5-3.5% premium. But perversely, it continues to sport a discount. This market also needs a reality check and the earlier, the better.

The author is economic advisor, ICRA