Watching the crystal ball is still a hobby for economists. Whether it’s forecasting gross domestic product (GDP) growth for the year or even a quarter, it has spread all over the world. With more data becoming available, there are more forecasts; and since these forecasts change regularly over time, one can always ask how many days these numbers hold. Economists like to quote Keynes on this. “When the facts change,” he reportedly said, “I change my mind. What are you doing, sir? Apocryphal or real, economists frequently quote it.
Making a prediction of the value of the rupee is particularly difficult. One must first consider India’s foreign exchange reserves, which have grown quite rapidly. Second, there are daily fluctuations caused by foreign portfolio investment (REIT) flows. Third, there is the external factor of the dollar. When the US currency strengthens against the euro, the rupee tends to fall and vice versa. Fourth, there is the concept of the real effective exchange rate (REER), a construct of economists in which relative inflation comes into play. The theory goes this way. If inflation in India is higher than in the countries associated with its basket of export currencies, then the rupee is overvalued and will correct itself through depreciation.
And the last consideration concerns reading the mind of the Reserve Bank of India (RBI). At what stage will the central bank intervene by buying or selling dollars to stabilize the Indian currency? Often, in seeking to answer this question, it is thought in the markets that the RBI is comfortable with some depreciation of the rupee, as it works in favor of exporters. Its corollary is that when exports increase, as they do today, the RBI can drop the rupee to help them, which it can also do by buying dollars.
It is therefore not easy to predict the exchange rate of the rupee against the dollar, as its objective factors are few and external factors have a stronger impact. The RBI maintains it doesn’t have a number in mind, but is ready to step in if there is excessive volatility. But what exactly defines this volatility? Likewise, the dollar is pulled by the US economy as well as by the policies of its Federal Reserve. The recent indication from the Fed that it would raise its key rate in the coming years was enough to strengthen the dollar and weaken the rupee. The Fed spoke of rate hikes, indicative of its fear that the US economy might overheat, growing faster than it can without proving inflation. As a rise in US rates could lead to a massive flow of money from global investors back to the United States, the dollar has gained in relative value. The inflation factor, however, has been curious. It was high in India last year, while global inflation was low. No one said the rupee was overvalued then, but people are today. Therefore, it is difficult to understand these factors.
Let’s try to assess the position now. An increase in foreign exchange reserves is an indication that India is earning more dollars than we spend, and therefore our combined current accounts and capital are in surplus. It is a comfortable situation which should last and ensure the solidity of Indian fundamentals. India’s current account will be in deficit this year, as imports will exceed exports, but will not be very high. Maybe 0.5-1% of GDP. The capital account can get blurry. Inward foreign direct investment was substantial in 2020-2021. With $ 60 billion in equity and $ 80 billion in total, it was one of the highest in the world. The REIT numbers will be influenced by the Fed, but currently remain positive. Therefore, capital flows are expected to remain strong. External commercial borrowing could slow due to weak investment in India. So, the fundamentals suggest that the rupee should be stable, with a tilt towards depreciation.
Now consider the external factors, which have a big role to play. The dollar should logically strengthen, given the improvement in US growth, now reinforced by the Fed. Indian inflation will be high in India and therefore also the REER of the rupee. To the extent that the market understands this concept and uses it for valuation, it should drive the rupee down. But the pressure will be less this time because global inflation is also increased by the rise in commodity prices. India’s inflation may not be that much higher than it justifies a steep depreciation.
The RBI factor was a game-changer. Its excess liquidity and accommodative stance did not work in favor of the rupee. In response to its April policy, when the RBI asserted its conciliatory stance, the rupee began to expect that if the RBI kept rates low in a time of high inflation and excessive borrowing on the market. market by the government, investors could potentially relocate. This pushed the rupee towards the 75 level against the dollar, but reversed over time as the RBI continued to inject liquidity and manage the yield curve. RBI dollar buy data is released with a lag. In April, he bought $ 4.2 billion worth of US currency. Exports rose sharply in the first two months of 2021-2022, and at this point the central bank would not want to spoil the party by delaying the depreciation of the rupee.
Considering all these factors, one can predict that the rupee will fluctuate in the order of ₹74-75 to the dollar, unless there is a shock of some kind, although none seems likely at this time.
Madan Sabnavis is Chief Economist, Care Ratings, and author of “Hits & Misses: The Indian Banking Story”. These are the personal opinions of the author.
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