Rupee needs world to be a better place

After a year of strong volatility, the new calendar promises to be better for the domestic currency as the government’s reform efforts are expected to draw large capital inflows

For the Indian rupee, leap year 2012 did not turn out to be good. The domestic currency saw high volatility during the year, sinking about 8 per cent since April on top of the 20 per cent it had already shed during January-March. Yet 2013 may not be bad and the rupee is likely to see a slight appreciation.

Yet, that appreciation may actually have little to do with the state of the domestic economy. It may have more to do with capital flows into the country.

“Next year, the rupee will see some correction. It could appreciate to 53 level,” predicts Centrum Capital’s head of treasury and foreign exchange Hari Prasad. Canadian bank, Toronto-Dominion Bank, is a little more optimistic. TD Bank’s research team expects the rupee to appreciate to 50.60 by the fourth quarter of the calendar year 2013. The expectation of a rupee appreciation, however, is largely driven by expectations of large capital flows, with the government’s liberalisation efforts.

Among sectors that are expected to see capital flows include the financial services sectors, particularly insurance; telecommunications and even physical infrastructure.

The expected flow of capital also is partly due to the quantitative expansion policies adopted by the US Federal Reserve board and the European Central Bank. Many financial investors and foreign institutional investors (FIIs) are expected to scour markets across the world for returns. This hunt is expected to drive their financial flows into India. In December alone, FII flows mounted to over $4.7 billion. Calendar 2012 has seen FII inflows of nearly $31 billion.

The flows are expected to pick up in 2013. Federal Bank president – treasury, Ashutosh Khajuria, said, “FII inflows will lend some support to the rupee. This calander, Nifty has given returns of nearly 24 per cent, which is among the highest in the world, and will encourage investors to flock to the country.”

FII investment initiatives taken during the year gone by, include raising the investment cap in sovereign bonds to $20 billion. Of this, the residual maturity criterion has been done away with for investments up to $10 billion. Yields in sovereign bonds in India are at present about 8.2 per cent at the short end and 8.15 per cent for 10-year maturities or at least 8 per cent higher than comparable US dollar treasuries. The yields are also higher by at least 300 basis points than countries like Spain that have a similar credit rating of triple-BBB-minus. Moreover, the category of external commercial borrowers has also been increased to include micro finance institutions.

Dun & Bradstreet economist Arun Singh, said, “The recently announced measures have partially boosted sentiment within the domestic industry and renewed interest of FIIs in the Indian market.” The improved sentiments were also evident from the credit default swap (CDS) markets. CDS, an over-the-counter derivative product, is technically for credit risk protection. Rising premiums indicate, mounting risk and vice versa. In the case of India, the indicator is the SBI borrowings. SBI’s CDS premiums are seen as surrogate for sovereign risk. It is down to $240,000 (or 240 basis points) for every $10 million covered, at present. In April, the premium was 326 basis points. The present premium was still far higher than the May 2010 level of 195 basis points. Yet India has better numbers than some EU member countries. At present, the premium for Spain is 320 basis points. For Italy, which is rated one notch higher than India, the premium is 270 basis points.

Some foreign direct investment (FDI) flows could mostly be through mergers and acquisition activities in the infrastructure segment, especially in telecommunications and power.

Telecommunications is highly leveraged due to high debt incurred in the 3G auction payments in 2010. Capitalising that debt would mean conversion of that debt into equity, leading to flows into the country. In the power sector again, capitalisation is beginning to occur. The latest being Lanco Infratech already putting its 1,200 mega watt Udupi Power project on the block and appointing Ernst and Young to find investors for the project.

On the other hand, foreign currency borrowings or external commercial borrowings (ECBs), another source of capital flows, remain slow. ECB borrowers in 2011 and 2012 were caught off guard, when the rupee depreciated, resulting in escalation of debt service costs. ECBs till November this year accounted to just $20 billion, or $3 billion less than the corresponding period of last year. Most of the fresh funding though was for refinancing debt.

Despite low ECB flows, there are still reasons for the rupee to appreciate. Inflation is decelerating. Core inflation or wholesale price inflation (WPI) is down to a 32-month low of 4.5 per cent right now. The WPI is down to 7.5 per cent. That brings down the inflation differential between the US dollar and the Indian rupee down to about 5 per cent. A 1 per cent inflation differential translates into a currency depreciation of about 0.8 per cent per annum.

That the currency depreciation is overdone was apparent from the Reserve Bank of India’s 36 currency real effective exchange rates (REER). A rise in the index implies that the rupee could appreciate and vice versa. In August, REER was down to a three-year-low of 90.30. In November, the index had improved to 91.22. Similarly, the six currency index that had dipped to 74.67 in June, when the rupee had hit a record low of 57 to the US dollar, improved to 75.33 in November. Both indicate an upward bias for the rupee.

Expectations of the rupee’s appreciation come on weak forecasts for international commodity prices. At present, India is running up a monthly current account deficit (CAD) of about $ 20 billion or close to about 4 per cent of the gross domestic production, largely on account of swelling petroleum import bills. HSBC MD and head of global markets Hitendra Dave, said, “Rupee will get support from a combination of factors in 2013 led by dipping oil prices. Expect the range to be between 53 and 56 to a dollar in the medium term at least.

India is a net energy importer. The World Bank’s forecast crude oil prices to drop to $105 a barrel. India’s present import basket price is $108 a barrel. International coal prices (Australia steam coal) are forecast to rise to $100 a tonne from the 2012 average of $95 a tonne. But then, most of India’s coal is imported from Indonesia and South Africa, where the prices are less than $90 a tonne.

But export prices are also unlikely to see any significant improvement next year, partly because deleveraging in the global markets are not expected to see any significant reversals. According to the International Monetary Fund’s estimates for 2013, the euro zone is expected to remain weak, with economies stuck at 0.2 per cent growth, as most of the member countries are already in a state of recession.

Besides, as the US moves to overcome the so-called fiscal cliff (end of tax breaks and beginning of tax increases, spending cuts and with the possibility of further increase in the national debt ceiling from the present level of $16.4 trillion), the outlook for exports also remain bleak. It was, therefore, not surprising that exports have suffered contraction. Exports of primary products to Europe contracted 3.4 per cent, manufactured exports 15 per cent and refined petroleum products 7.2 per cent in the first half of this year. Exports of manufactured goods and petroleum products to the US fell 2 per cent and 25 per cent for the same period. Only primary export products grew 147 per cent, though international prices have fallen (see special report on export opportunities in this issue). That in turn meant that India current account would remain in deficit.

Canara Bank’s chief economist, Manoranjan Sharma, cautioned, “The government has initiated the reform process. That is positive. But inflows are still dependent on the situation in Europe and the US. The economic environment in that region is still fluid at the moment. Then, there is a volatile West Asia that can upset the energy bill.”

Currency expert Jamal Mecklai, added, “There are a number of global issues that may impact the rupee. That includes the US fiscal cliff.”


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