Latest India reports from most analysts have bracketed the South Korean won and the Indian rupee as the weakest performers in Asia. In a span of three months, the rupee has lost more than 7% of its value against the US dollar.
This is interesting as the growth numbers of the economy, despite being continuously revised downwards, are still projected at above 7.5% for 2007-08 and closer to 8% for 2008-09. The current account deficit projections have indeed widened. That is now expected to breach 2% in financial year 2008-09, instead of 1.5% at which financial year 2007-08 is expected to close out. The inflow of foreign currency into the economy has slowed down. In the stock market, foreign institutional investors have been net sellers in April. Year-to-date (end April), they have sold more than Rs 108.9 billion.
But the lagged inflow is a reflection of the global weakness among funds to invest in the emerging market economies as a fall out of the rise in interest rates in the US. And the current account deficit actually opens up room for RBI to absorb more foreign money into the economy. This was, so far, held out as a sort of roof beyond which sterilisation operations became necessary. So the factors influencing the currency remain the same: the current account deficit, large investment inflows over-funding the current account deficit, and a persistent central bank intervention to help recycle this balance of payments surplus. The key therefore seems to be the operation of the same factors but with a different perspective that is making the rupee nervous.
This is where the macro economic perspective comes into play. Last year it seemed there was little that the economy could do wrong. In the 2008, nothing seems to be going right. The big differential that has opened up in the macro economy is the nightmare combination of mounting oil imports at a sharply inflated price and an inflation that refuses to cool down. The forex reserves would probably be drawn upon for inflation management to pay for the rising commodity imports. And that means a further pressure on the rupee to dip. A currency reflects the underlying strength of the economy. So last year if the rupee appreciation meant an endorsement of the rising pulse of the economy, the dip is a similar reflection that the economy is slowing up. This is where the differences between the Indian rupee and the other Asian currencies are likely to become intense. This is a key weakness that is likely to persist in an election year. The spectre of the impact of a domestic slowdown is making the prospects of the rupee making a comeback pretty slim.
In this scenario, monetary policy from RBI is focused almost exclusively on inflation. The expected reaction from RBI will be to clamp further inflationary expectations. Given that systemic liquidity has dwindled to around Rs 1,000 crore at RBI?s LAF reverse repo window, liquidity measures like the CRR will have an unwarranted effect on call money volatility. The logical next step should be to increase the repo rate and to curtail bank credit growth as a measure to further slow M3 growth.
So what is the outlook for liquidity over the next couple of months? It is important to get a fix on this. If RBI expects liquidity to be surplus and the inflation environment to remain the same, that would translate into more liquidity management measures like April?s two-stage 75 basis points CRR hikes.
A very interesting part of the rupee scenario is the expenditure pattern of the central and state governments. In April, they have drawn down their balances with RBI, from Rs 84,000 crore at end-March to
Rs 17,000 crore. A large part of this was fuelled by the advance tax collection in mid-March.
Also, savings deployed into tax-exempt mutual funds and other investment vehicles at the end of the year have now got back as wholesale deposits with banks. This means bank credit growth during April, has been lower than deposit inflows.
According to an Axis Bank study, these flows are also likely being reinforced through another seasonal factor that comes into play in the first week of May: bonuses. A large segment of corporate India gives out its variable pay around this period. While a significant share of this would merely be intra-bank transfers from corporate to salary accounts, and therefore liquidity neutral, some amounts are likely to have been directed towards equity and other asset markets. Conservative estimates of the addition to liquidity from these bonuses, net of intra-bank transfers, might be in the region of Rs 500-750 crore.
It is, therefore, a safe bet that the rupee is unlikely to recover soon, at least until December. By then the liquidity overhang in the economy will have dried up and the restrictions on the flow of foreign capital will have begun to ease. The nature of the US downturn will also have revealed itself. The extent to which the oil subsidy will be covered will also become clear.