The correlation of the Indian Rupee to the currencies of developing economies has always been extremely rocky and the start of this can be attributed to the era post the Prussian War or Circa 1870-71. Given the purchasing power disparity between economies trading in gold versus those trading in silver and the demonetization of silver as newer reserves were being discovered, the impact of such a huge rift was profound.

Post Independence, the economic crisis of 1966 and 1991 have attributed to the weakening of the rupee further in global markets. The trade deficits of 1950, resultant inflation and the stopping of foreign aid, the war of 1965 and drought devalued the rupee further. Subsequent liberalisation helped stem the flow till 1991, when India started facing its next wave of Balance of Payment Issues from 1985 – 1990. With imports restricted and high deficit, the rupee was devalued yet again especially by 1999.
Between 2000 – 2007, with high remittances, sustained foreign investment inflows and the development of exports in the sectors of outsourcing and technology, the rupee led a strong battle against the USD. The year 2008 was a watershed year for FOREX trading in India. In October of that year, the RBI & SEBI allowed Indian stock exchanges, viz., NSE and MCX to offer trading in foreign exchange derivatives. In the initial phase, trading was only allowed in future contracts involving Dollar/Rupee, Euro/Rupee, GBP/Rupee and Yen/Rupee combinations. Subsequently in October 2010, NSE introduced options contracts on the Dollar/Rupee as well. Over the last 5 years, we have seen participation – both institutional and retail increase in both, the NSE and MCX.
Both Non–Institutional and Corporate investors are increasingly turning towards the exchanges for hedging their foreign exchange exposures. In the above charts, we see a sharp decline in volumes around Q3 FY12, on account of imposition of turnover charges by NSE and MCX, which caused a drop in participation from proprietary traders. However, since the end of last year, volumes have improved given a more active and increased participation from Corporates drags on exports. That coupled with simultaneous high levels of inflation and low levels of investment and consumption stimulating fiscal policy makes imports competitive to domestic produce and causes the inherent trade deficits to widen.
The slowdown in the domestic economy is reflected in the slowing of the new orders component of the PMI (Purchasing Managers Index) in manufacturing as well through anemic industrial growth. PMI is a diffusion index, where the level 50 separates expansion from contraction and is also a survey of business managers, whose responses are mapped according to various sub-components. Export continues to lag behind imports in terms of growth, as in August the merchandise imports de-grew 5% whereas, merchandise exports de-grew 10% given which merchandise trade deficit continues to remain elevated.
Over the last few weeks, three significant events have emboldened the risk-on mood in financial markets. First, it was the commitment made by the European Central Bank towards unlimited amounts of bond buying programs for fiscally stressed nations. Purchases however are conditioned upon the member state formally seeking a bailout and then adhering to the conditions imposed by the EU/IMF/ECB Troika for fiscal consolidation. The ECB also relaxed the collateral norms, which in turn, will help banks to pledge assets to secure funding from Central Banks. The effect of the ECB’s decision was a sharp decline in the bond yields of Spain and Italy and rally in their respective equity markets as seen from the charts below.
The second significant event was the ruling by the Constitutional Courts in Germany rejecting the motion to block permanent bailout funds from the Euro zone and ESM as was widely expected. The news was met with cheers from the risk assets – What does this mean? while the Dollar tumbled. While the ruling was a preliminary one and full review will be considered together with ECB’s planned OMT (what is the full form of OMT and its function?) in December, the EZ could convene the first Board of Directors meeting for the ESM as early as October 8, 2012. Nonetheless, the court also requested that Germany’s liability through the ESM must be capped at agreed EUR 190b levels. The overall lending capacity of the ESM has been capped at Euros 500 billion. What is the impact of this ruling specifically?
Finally, the US Fed adopted a much more dovish stance than was expected, when they not only announced a fresh round of open-ended purchases of mortgage backed securities of USD 40 billion a month, but also extended theinterest rate guidance from 2014 to 2015. Aptly named quantitative easing, the third round of stimulus includes massive bond-buying initiatives which would stabilize the US Economy through the housing sector and the stock markets. The Fed has also committed to continuing the purchases of MBS (full form) till labor market conditions improve substantially. This means that such purchases could continue for well over a year, with possible additional purchases if the need arises.
This open ended commitment for more purchases means that the US Federal Reserve could look to purchase additional round of treasury securities once Operation Twist ends in December. If that does happen, then the Fed’s balance could expand significantly from current levels of USD 2.8trillion to between USD 4-5 trillion by end-2014 according to certain estimates.
A significant ramp up in the Fed’s balance sheet could be inflationary (for US or India) Already commodity prices have rallied on the announcement and we fear that as the super easy policy continues, oil and edible commodities might see further upward spikes. Anecdotal evidence suggests that after QE1 and QE2 stimulus packages, commodity prices especially that of oil, rallied quite significantly.
It needs to be noted that a weaker US Dollar, could hurt other exporting countries, like the EMs and Euro Zone nations. Hence, beyond a point, this could spark a call for an all-out race for devaluation around the globe. In the garb of using easy monetary policy to help the ailing economy, Central Banks could be forced by respective Governments to weaken their currencies. This in turn can lead to a perpetuating highly inflationary cycle in the global economy and what else in terms of affecting currencies specifically?
Currently, the Indian Rupee remains capped within a well-defined upward trending channel with the spot having taken support around the primary uptrend line. In case, the pair slips below the trend line, which would be below 53.00 on spot, and sustains then it can test the mid-line of the channel around 51.70/52.00 on spot levels. There is good chance that that USD/INR holds the primary trend line above 53.00 and then goes into sideways consolidation. However, in case the pair slips through the 53.00 handle then we would expect mid-line to offer a strong case for a floor under the Dollar/Rupee rate.
This is a Guest article by Kotak Securities.
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Indian Rupee: Volatility ahead by Anindya Banerjee, Currency Analyst, Kotak Securities
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