Indian rupee - the new Thai baht?

Unlike the appreciation of other Asian currencies, the magnitude of gain seen in the rupee is phenomenal
Rohit Chawdhry

Mark Mobius recently commented on Bloomberg that the Indian rupee remains undervalued by 16 per cent. And hence, capital flows may continue to flow in that country due to a mean reversion towards attaining its appropriate value. Clearly, 2007 is panning out that way and so it seems that it just never ceases to surprise in Asia. First the Thai capital controls spectacle on the eve of the new year, then a very wild run of China numbers in the first quarter, culminating in what may be the first mainland led global market correction – and now India. Or more specifically, the Indian rupee, which recently attained it nine-year high.

For the last 24 months, the India story has been the stellar rise of the equity market, but no longer. It’s now the rupee’s turn. The rupee had a relatively dull start to the year, hovering above 44 to the dollar in January and February, but by early March the rupee suddenly began to run ... and run ... and run, strengthening a full nine per cent against the dollar in the last two months.

As one can see from the chart, this is about as close as currency markets get to a vertical line. Though other Asian currencies, including the yuan, have also appreciated during this period, the magnitude of gain seen in the rupee has been phenomenal.

What’s more, as of now there is no end yet in sight. Which brings us to three questions. What’s driving the rally? Will it continue? And could this turn into a Thailand-style rout, where the sheer unsustainable pace of inflow forced the authorities to do something precipitous?

Why the rally?

This is perhaps the easiest of the three questions to answer. By definition, the market has been pushing the rupee higher – and by definition, given its history of intervention and guidance on the exchange rate front, the central bank decided to let it go. Why has the market become more interested in the rupee than in the past? For an explanation, look no further than the combination of rising interest rates, the stabilisation of the current account and the improvement in the external financing mix. By far the most important of these are the interest rates; successive policy tightening and lower liquidity levels in the banking system resulted in a steady rise in market interest rates over the past 18 months. And the magnitude is anything but small – by February 2007, short-term rates were 200 basis points higher than the mid-2006 level. No other Asian country saw anything close to this amount of tightening over the past year.

Needless to say, the prospect of an eight per cent onshore yield against what had been a stable rupee exchange rate proved attractive to overseas investors. And this is all the more true since the big risk factors to the external balance were visibly fading.

In this later cycle tightening environment it was natural to expect investors to take advantage of higher rates. And sure enough, in February, the Reserve Bank of India (RBI) recorded the largest-ever accumulation of official forex (FX) reserves of nearly US$23bn, as the central bank was forced to intervene heavily to buy up capital inflow.

With the current account continuing to be in deficit, this increase in reserves is driven by strong capital inflow. This surge in inflow and rising cost of the sterilisation appear to have triggered the shift on RBI policy to allow faster appreciation in the rupee. So why did the RBI decide to let the rupee go, instead of continuing to intervene?

The short answers are that:
(i) the domestic economy is still very hot, i.e. RBI is not interested in letting large amounts of liquidity rush in through the FX accounts,
(ii) sterilisation looks like a very expensive option at the current level of interest rates, and
(iii) the exchange rate appreciation serves as an effective tightening measure in lieu of further interest rate hikes.

In early March this year, the Indian central bank made a clear shift in its exchange rate management approach allowing faster appreciation of the rupee. The rupee has appreciated by about nine per cent since early March, compared to 3.4 per cent appreciation in the preceding six months. Apart from reducing the pressure on liquidity management, the curr-ency appreciation will only help in reducing the inflation pressure (see chart).

Will the appreciation continue?

In the short-run, most indicators point out that appreciation of the Indian rupee is well done. However, the long-term view (2-3 years) is a different bet.

After the recent sharp appreciation, on a real effective exchange rate basis, the rupee has moved further away from its mean by about ten per cent. The medium-term implications of the over-valued currency for macro stability are that the RBI may have to start intervening soon to soften the pace of appreciation. However, this intervention would also necessitate further hike in the cash reserve ratio. However, purely on inflation differential basis, the Indian rupee remains overvalued by ten per cent. Adjusting it for productivity differentials as well would imply an undervaluation of around 15 per cent. Which measure is more appropriate to measure over/underval-uation? Usually, usage of both inflation and productivity differentials is more common (and accurate) than just inflation differentials.

A case in point is China. If one were to adjust Chinese yuan for just inflation differentials, its undervaluation versus the dollar works out to 5-6 per cent. However, incorporating productivity differentials (between the US and China) implies an undervaluation of around 40 per cent. If indeed, the Indian rupee is undervalued by 16 per cent, then the fair value of the Indian currency is more likely to be close to 35-36 against the dollar. That is a level which may take a couple of years to attain.

Will the rupee go the baht way?

Will it be capital controls next, just like the way it was in Thailand last December? While RBI may continue with the intervention for the next three months or so, if the pressure of capi-tal inflow persists, it may have little choice but to initiate some capital controls on debt-oriented inflow. Some soft measures have already been announced recently – such as limiting returns on non-residents’ deposits and restrictions on banks’ borrowings from abroad. Although it may be mentioned here that the rupee hasn’t strengthened nearly as much to date as the baht did during 2005-06, but at the current pace it wouldn’t take too long for the rupee to catch up.

Broader view is that the rupee is more like ‘mini baht’. There are some obvious similarities between the two cases, but there are also key differences.

The similarities include a positive carry differential between onshore short rates and global funding costs, currencies that have already begun to move up sharply, improvement or stabilisation of the external trade balance, and central banks who are focused heavily on inflation as the main policy goal. As in Thailand, the currency is much more likely to strengthen in the late cycle period, when current account constraints are fading and interest rates are at a cyclical high.

In India, by contrast, the currency does not show up in the metrics as undervalued. The current account is in deficit and the economy has been dependent for net capital inflow for a while now. The stock market is trading at very mature valuations and the external position is more exposed to global credit conditions.

In short, although current interest rate differentials are attractive indeed, the rupee is far from a ‘one-way bet’. So what’s the take for the next 3-5 months? Perhaps 43-44 band would be a more appropriate forecast for the next quarter or two from its present level of 40.53 against the dollar. In the long-run (2-3 years), expect the rupee to gravitate towards 35-36 against the greenback.