The sky is bright this summer for investors in India. No concerns on political front as BJP led NDA has secured a rock solid position. There is a growing optimism about recovery of Indian economy. Foreign Institutional Investors (FIIs) have been flooding Indian markets with capital. Indian retail investors too have started coming back to equity. What could be missing is sharp rise in value of Rupee. It is up only about 5% in 2014 so far. Considering the ease in Current Account Deficit (CAD), lower trade deficits and heavy FII inflows, rupee has resisted a major upswing.
Has Rupee Recovered Fully?
Data as on May 21, 2014
Source: ACE MF, PersonalFN Research
Indian currency had taken a terrible hit in the 2nd half of 2013. Rising CAD, sinking economy and lack of policy thrust were the primary reasons behind falling currency. Talks of Federal Reserve (Fed) rolling back financial stimulus in the U.S., led to withdrawal of USD from emerging markets. This also affected the value of Indian rupee. As a remedial action, Indian Government imposed curbs on gold imports which led to fall in CAD. As the sentiment slightly improved, rupee recovered from lows it made in August 2013.
You might be wondering as to why appreciation in rupee is limited despite positive scenario. PersonalFN has the answer.
RBI Action
RBI was criticised for being unable to convincingly arrest the downfall of Indian Rupee last year. As a last resort, RBI aggressively sold dollars which caused India’s forex reserves to dip considerably in September 2013. However, RBI seems to be preparing well in advance this time. Now that, FIIs are investing aggressively in India, rupee would appreciate sharply if RBI doesn’t interfere in the forex market. Taking this as opportunity to build war chest of forex reserves, RBI has been aggressively buying dollars. As a result, from the lows of USD 274.8 billion in September 2013, India’s forex reserves have grown to USD 313.8 billion in May 2014. As reported by Financial Express dated, May 21, 2014, RBI has bought nearly USD 20 billion since February 2014. It includes purchases worth USD 4.1 billion in May alone, so far. It is observed that, as soon as dollar slips below 60-mark against rupee, RBI starts buying dollars. This has been restricting the upside in Indian Rupee.
What is the impact?
When RBI buys dollars, it has to release INR in the system. As a result, there is a possibility that liquidity may ease. This poses an inflationary risk. RBI has set a target of achieving 8% inflation in 2014. Retail inflation as measured by Consumer Price Index (CPI) climbed to 8.59% in April. RBI might now take measures to absorb excess liquidity caused on account of dollar buying. Some of the common measures can be taking reverse positions in the forward markets, or selling bonds in the domestic market.
PersonalFN is of the view that, although FII flows have been robust so far, they might quickly reverse if the sentiment turns negative for any reason. It is also possible that, FIIs might look for more attractive investment opportunities outside India. In that case they may start selling in India and buy elsewhere. Fed has already started discussing exit strategies of monetary stimulus. This may result in appreciation of USD. PersonalFN believes, today, India is better prepared for such events than it was in August-September last year. Although it is reasonably clear that Fed won’t increase interest rates in hurry, it may take some decision regarding exiting stimulus by June.
Movement of rupee doesn’t only impact importers and exporters. Investors are also affected. Falling rupee is a bad sign equity and debt markets. Yield on India’s 10-Year sovereign bond might appear to have fallen from highs of over 9% to 8.75%. But rupee-dollar equation may push it up once again. PersonalFN is of the view that, short term debt funds might stay attractive for now. Having said this, PersonalFN recommends investors to consider their time horizon before investing in debt markets.
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