The economy will adjust to the new Rupee levels over a period of time. The differentials with the US economy are wide enough for the Rupee to stem its seemingly free fall. India is growing at 7% while the US is growing at 2.5%. US Federal Reserve (Fed) rates are at close to zero percent while RBI’s repo rate is at 8%. Ten year bond yields in the US is at 2% while in India it is at 8.6%. True macro economic differentials alone will not help the Rupee, but investors will at some point of time go back to searching for higher yielding currencies.
In the adjustment period however there will be volatility in financial markets. Investors will have to ride out the volatility and look at the bigger picture going forward. The bigger picture still says buy India rather than sell India.
The India Rupee (INR) is again trending towards record lows seen in December 2011 and there is a fresh round of nervousness in the markets on the fall in the currency. The INR has lost 20% against the US Dollar (USD) over the last ten months and there does not seem to be any respite for the currency at present. Poor trade deficit numbers for fiscal 2011-12, reversal of portfolio flows trends in April 2012 and broad USD strength globally have accounted for the weakness in the Rupee.
Trade deficit for fiscal 2011-12 was at record highs of USD 185 billion, up by over 55% over the deficit for 2010-11. The widening trade gap has taken up the CAD (Current Account Deficit) to 3.6% of GDP in 2011-12 against 2.6% of GDP in 2010-11. FII flows were negative in April 2012, the first month of negative flows in calendar year 2012 on worries of GAAR tax issues. The USD index, which tracks the USD against six major currencies is up by over 6% over the last ten months on the back of expectations of the US economy doing better than other countries in the developed world
The weak Rupee raises questions on the performance of Indian equity and debt markets going forward. A weak Rupee is seen as a signal for FII’s to pull money out of the country’s equity and debt markets leading to fall in prices of stocks and bonds. A weakening Rupee is also inflationary as the government’s fuel and fertilizer subsidy bill goes up leading to a widening fiscal deficit. A weak Rupee affects monetary policy as USD sales by the RBI to stem currency volatility sucks out liquidity from the system, which the RBI has to replenish through bond purchases.
A falling Rupee is definitely a cause for concern in the near term. However in the longer run, will it really matter for domestic asset prices? On a longer time period from 1995, when the economy started opening up till date, the Rupee is down 60% against the USD. However equity indices are up six fold in the same period of time. Bond yields are down from high double digit levels seen in the 1990’s to single digit levels and inflation is also down from high double digit levels to single digit levels. The correlation between the Rupee and financial markets breaks down at some point as seen over the longer term.
The current weakness in the Rupee will affect equity and bond market sentiments on worries of FII outflows. However FII’s are not likely to take out money in hordes from these levels and even if they do, they will not get an easy exit as once FII selling is perceived, markets will front run the selling and make exits almost impossible at low impact costs. For example if FII outflows are expected, speculators will drive down the Rupee to Rs 56 levels while the Sensex will be pulled down by 10%. FII’s may not come in aggressively into the country on Rupee worries but will not take out money aggressively either.
