Conjecturing the direction of movement in exchange rate has been fraught with as much risk and adventure as trying to gauge the movements in the stock market. The exchange rate is affected by fundamentals as well as extraneous conditions. Fundamentals get reflected finally in terms of changes in forex reserves, as this is a reflection of total inflows and outflows of dollars to and from the system. The net balance is indicative of the strength of the external account. Hence, if reserves are increasing, exchange rate has to logically strengthen. However, there are external factors, too, which are at play—these affect the value of the rupee. The first is the global anchor currency—the dollar—and its relative strength. When the dollar strengthens or weakens in international markets, then generally all the currencies move in the opposite direction. Hence, as the dollar has been behaving quite incongruously vis-à-vis the euro and declined by 3.5-5% since April relative to FY17, other currencies have tended to strengthen on this score. Those which have not are the ones whose fundamentals are weaker.
Another factor that comes into play is the movement in other competing currencies. While this may be difficult to quantify, it is normally felt that when the rupee is getting stronger, it has to be compared with movements in other emerging markets currencies that compete on the exports front. Hence, if these currencies are falling while the rupee is rising, then there could be some action by the central bank to prevent the appreciation, which then buys dollars in the market. Therefore, trends in movements of other currencies also become important.
Today, the rupee appears to be on weak ground when it comes to fundamentals because the current account deficit has become shaky. The first quarter shows a deficit of 2.4% of GDP, which is quite high as the numbers were much lower last year. Within this set of flows, the trade deficit will almost certainly widen going ahead, due to the inherent tendency of imports to increase at a faster rate than exports—which are tied to the prospects of the global economy and which are not yet too strong.
The other receipts on the current account are still under a cloud. Software receipts that could bring in around $60-65 billion a year are at the background, waiting for clarity on the outcome of policies in the US and the UK as these countries have turned protectionist and could lower the demand for any kind of outsourcing. Remittances, which could also get in a similar amount, have been volatile of late for a different set of reasons. Ever since the price of oil has come down, there has been a slowdown in the Gulf area, which is the most important source of remittances. Therefore, the current account deficit will remain weak.
Support so far has, however, come from the capital account where foreign investment has caught on. Foreign portfolio investments, in particular, have been bolstering the dollar flows, which have primarily been in the debt segment. As these limits get exhausted and are not widened, there would be limitations on the quantity of money that would come in from this source. Flows into equity have been whimsical, while FDI has been at almost the same level as last year. NRI deposits are just about stable and, with rates coming down in India, would cease to be attractive for this category of savers. Hence, future prospects do indicate a weaker rupee. However, this has not been the case this year.
In this context, the accompanying table maps the changes in the forex reserves and the rupee-dollar rate, which shows the impact of fundamentals. Alongside, the average change in other four BRICS currencies is juxtaposed (assuming equal weights for all of them). The emerging picture is definitely not clear.
Reserves have been increasing almost continuously since FY14, though the quantum of change has been lower since FY15, which was the year when swap facility was provided by RBI on FCNR(B) deposits, or foreign currency non-repatriable (bank) deposits. Notwithstanding the repayment made in FY17, growth was still positive. The rupee depreciated at a high rate in FY13 and FY14, even when the forex increased in the latter year. This may be explained by the fact that FCNR deposits came in the third quarter.
The average elasticity of change in exchange rate on account of change in forex reserves is 0.57 (excluding outliers FY13 and FY15). Hence, if forex reserves increase by 5%, then the rupee actually falls by around 2.5-3%. Given that the actual numbers are not in conformity with the direction, it may be concluded that the fundamentals do not drive the market.
How about other currency movements? For FY18 so far, the rupee has appreciated by 4.1%, which is broadly the same as the G4 considered here. However, the renminbi has remained almost flat with slight depreciation, while the other three have strengthened with the rouble being the best performer with an almost 8% increase. In the other years, too, there has been no clear relationship between the two, which indicates that even this theory, though logical, may not really be driving the currency.
The conclusion that can be drawn is that the factors driving the rupee are still not clear. While economic logic does point to certain factors that seem logical, often the movement is quite contrary to expectations. Sentiment plays a big role as well as active intervention from RBI, which may be buying or selling dollars to steady the rupee. RBI has measures in place to curb the speculative part of the market, but expectations remain firm. Under these circumstances, taking a call on exchange rates is all the more challenging. Currently, based on fundamentals, which include slowdown in the flow of FPIs, the rupee should be logically expected to move towards the 65-65.5 mark by the end of the year. While the rupee was strong at around 64 per dollar for long, a single day jerk to Rs 64.5 on September 21 was least expected. This even beats the stock market idiosyncrasies.
Authore is Chief Economist at CARE Ratings. Views are personal.