[ This article has been written with inputs from Mr. Ashustosh Gupta & Surbhee Sirohi of Financial and Investment Research services firm Evalueserve ]
The USD-INR exchange rate is an important indicator of investor sentiment and can significantly impact not only the fortunes of individual firms and sectors, but also the government.
While this exchange rate has been very stable overall for the last five years, there have been periods of significant volatility. For example, USD-INR moved from 40 to 51.50 from March 2008 to March 2009. We believe there is a significant downside risk to USD-INR exchange rate and will explore some of the risk factors here:
Inflation is at an all-time high; the Consumer Price Index (CPI) increased by 10.88% in 2009 and by 13.19% in 2010. The monetary policy changes to control inflation have been ineffective. We believe this is because inflation is being driven primarily by structural supply side challenges such as lack of agricultural infrastructure, low crop yields, low organized retail penetration, and lack of import buffer for staples such as pulses where India is one of the main producers worldwide.
India as one of the fastest growing economies should be a favoured destination for investment. Nevertheless, it witnessed a decline in Foreign Direct Investments (FDI) in 2010, making it the only BRIC country where this happened. This is troubling as FDI is an important indicator of investors’ faith in a country’s long-term prospects. Foreign Institutional Investment (FII), which provides short-term portfolio investment money inflows, has been buoyant, but these funds are volatile by nature and are prone to “flight risk”, something that happened during the financial crisis.
Recent widespread corruption scandals have reinforced the negative perception of governance deficit in India. This, combined with regulatory and tax uncertainty, will deter foreign investors. For example, several global firms who invested in India’s telecom sector have had to write off billions of dollars of their investments.
A major source of foreign currency inflows to India is remittances; India received USD 55 billion in remittances during 2010. The Middle East accounts for a major share of this inflow and the current turmoil in the region may negatively influence it.
The combined central and state government deficit has stubbornly stayed around 10% of GDP. Another major concern is that India imports about 70% of its oil and efforts to increase the production capacity of petroleum and natural gas domestically have not been very successful.
India’s current deficit is about 3%, the level it reached during the crisis of the 1990s. A current account deficit is not bad by itself for a growing economy if it helps build important long-term productive assets. Unfortunately, some of this money already seems to be feeding speculative real estate activity instead. This is exacerbated by the fact that the more volatile FII money (and not the more stable FDI) is funding the current account deficit.
The US economy seems to be on the path to recovery. It is very likely that the improving US economy will draw more funds at the expense of emerging countries. This can already be seen in the FDI inflows, which increased by 43% in 2010.
After studying the various demand and supply factors for the Rupee, we have arrived at three likely scenarios:
First Scenario – Rupee Depreciation
This scenario is likely to occur if oil prices continue to rise or if FII money “exits” because of a crisis of confidence. Based on past evidence, even a relatively orderly outflow of USD 15 billion of FII money over a year could result in the INR depreciating by 22–30%. This would imply an exchange rate in the range of INR 55–60 to USD 1. It could get even worse if the flight of capital were to take place over a shorter period. This would imply a higher cost of petrol, diesel, and petroleum products in India, leading to even higher food prices and Consumer Price Index. The current account deficit would balloon and the rising inflation could create a vicious cycle.
Second Scenario – Rupee Appreciation
This scenario is likely to occur if the FII money continues to flow in and FDI levels improve. An appreciating Rupee will make imports cheaper and lead to better managed deficits and inflation. The flip side is that Rupee appreciation would erode India’s cost advantage in the export sector especially the booming ITES sector and likely invite government intervention. This is what happened just before the onset of the 2008 financial crisis when the USD-INR touched 39 and the Indian government repeatedly intervened in the currency markets to halt the Rupee appreciation.
Third Scenario – Status Quo
This is the most benign scenario. The exchange rate continues to move in its current range and slowly appreciates over the long term as the economy continues to develop and India strengthens its position in the global markets. The government’s efforts to improve agricultural infrastructure bear fruit in the longer term and inflation declines. Exchange rate fluctuations do not cause any major disruption in the trade environment.
According to our analysis, during the next two years the probability of the first scenario (depreciation of Indian Rupee by 20%) is the highest (about 50%) while the other two scenarios have an equal probability of approximately 25% each. In other words, there will be pressure on the Rupee unless steps are taken to fix structural issues described in this article. The Indian government and RBI are well aware of this risk and are definitely hoping for the third scenario, in which India essentially grows its way out of trouble over a couple of decades and where they only have to intervene occasionally to smoothen out excess volatility. As Subir Gokarn, a deputy governor of RBI recently said, “Intervention is not costless; it simply transfers the cost from one constituency of the economy to another.”