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Economy Nov 23, 2011

The hype and hysteria over the rupee’s fall is overdone

By Venky Vembu

The rupee's sharp slide in recent months - by as much as 16 percent against the US dollar since July - has given rise to a lot of anxiety about how long the depreciation will continue, and the effect it will have on inflation.

The equity market has been tanking on sustained fears of a worsening of imported inflation and a slowdown in economic growth. The seeming reluctance of the RBI and the government to directly intervene in the currency market has accentuated these concerns.

But this anxiety, while understandable, is also feeding an excess of mass hysteria and ill-informed commentary among analysts - and over-the-top panic in the markets. Even international investors appear to have been spooked by the rupee's fall: UBS economist Jonathan Anderson notes that his email inbox is choking with "panicky correspondence" from investors seeking to understand what the rupee's slide portends for the larger India growth story.

Rupee

Media commentators are now arguing that if the rupee's depreciation continues, it will have an overhang effect on imported inflation. Pawan Kumar/Reuters

Media commentators are now arguing that if the rupee's depreciation continues, it will have an overhang effect on imported inflation, which would mean that the RBI may not be able to stick to its decision, taken last month, not to raise interest rates going forward.

In many cases, even the analyses about the underlying reasons for the underperformance of the rupee, which is far and away one of the worst performing Asian currencies in 2011, appear to be clouded over by an inadequate appreciation of fundamentals.

The 'red flags' aren't really red

For instance, three 'red flags' on India's macro condition are cited as explanations for the rupee's slide: rapidly falling economic growth, untamed (and seemingly untameable) inflation, and a stampeding by corporates to refinance US dollar borrowings.

"The trouble," says Anderson, "is that none of these explanations really make a lot of sense."

It's true, of course, that economic growth has slowed down throughout this year, but there's nothing to say that this should automatically be negative for the rupee. In fact, by reining in the external balance of trade - which is by far the biggest driver of a currency - a relative slowdown such as what India is experiencing should have the opposite effect on the rupee. And India's trade deficit is being kept under control.

Likewise with inflation. Consumer price inflation in India today is, on average, around 3 percentage points higher than the average across emerging markets. Yet, in 2010, when Indian inflation was as much as 10 percentage points higher, the rupee actually strengthened against the US dollar, and fared even better than its peers in the universe of emerging markets. At that time, analysts explained the rupee's rise by arguing that higher interest rates, intended to fight inflation, would be good for the rupee, and that in any case the RBI seemed keen to allow the rupee to rise as a way of tightening.

In other words, higher-than-average inflation need not always translate into a weaker rupee. And "it is very hard to point to any wrenching shift in the inflation or policy outlook that might have caused the recent rupee underperformance," adds Anderson.

Even the third pillar of the argument doesn't stand because among the universe of emerging markets, India actually has the lowest short-term external debt ratios (3 percent of GDP), and given the capital controls in place, it doesn't have excessive foreign positioning in local debt markets.

The one thing that has changed about India's currency macro is that its net reserve coverage buffer as a share of GDP (defined as foreign exchange reserves plus the annual current account balance less the short-term external debt outstanding) is today around 9.1 percent of GDP, a fall from 14 percent in 2008. With most other emerging economies, that buffer coverage actually increased since 2008. This puts the rupee squarely in the category of "risk currencies", which is why in the heightened risk aversion over the eurozone economies, the rupee has fallen sharply harder.

Which also means that so long as the fears of a eurozone crisis are top of the mind, the rupee will suffer from heightened risk aversion. But equally, any return to the risk-on trade would almost certainly see a rupee rebound.

Interest rates need not go up

There's been some speculation that the imported inflation that would be set off by a weaker rupee would perhaps lead the RBI to go back on its pledge not to hike rates (and even cut rates if inflation falls below 7 percent). That argument too is flawed.

Indicatively, Indian WPI inflation is driven rather more by the percentage year-on-year change in rupee-denominated international commodity prices. Credit Suisse economists have calculated that even if the rupee-US dollar exchange rate remains at the recent low of 53.3 and the level of international oil, food and metal commodity prices remains unchanged, it won't have a significant impact on WPI inflation.

They in fact see WPI inflation dropping to 6.5 percent by March, even lower than the RBI's projection of 7 percent.

By their estimation, rupee-denominated commodity price inflation will rise again only if the rupee depreciates by another 20 percent against the US dollar - and reach 70 against the dollar - by March 2012. That's unlikely to happen.

Scope for rate cuts still exists

This is because of a high base effect of rupee-denominated commodity prices: they rose strongly between October 2010 and March 2011. That base effect may be enough to ensure that WPI inflation will come in lower than 7 percent by March - and for the RBI to in fact begin to cut interest rates.

So, there's absolutely no need to lose your head over today's exaggerated rupee slide or the headline inflation numbers. The numbers certainly look daunting, but there's the encouraging prospect of a retreat in WPI inflation and perhaps, if the risk-off trade sentiment turns around, for the rupee to regain a bit of lost ground.

by Venky Vembu

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