Should RBI let the rupee depreciate further against the dollar?

Might not want to allow a sharp fall, as this can prove risky for portfolio investments

Since November, the rupee has depreciated three per cent against the dollar and a further drop seems possible. However, it has appreciated against most other currencies. As a result, for the first time in 10 years, the real effective exchange rate (REER) and the rupee's value against the dollar have diverged, says Credit Suisse. This divergence leads to confusion, both for the Reserve Bank of India and investors. While relatively stronger foreign currency reserves will put an upward bias on the rupee, the Reserve Bank of India (RBI) will be under pressure to intervene and prevent appreciation, as the REER index is at 110 (36 currency basket), suggesting the currency is overvalued. India's long-term REER average is 105.

This poses a dilemma for RBI. Should it let the rupee rise against the dollar or allow it to depreciate? There are no easy answers to this because what happens to the rupee will have a direct bearing on foreign portfolio investment in debt and equity. While calls for a rate cut have increased following a sharp decline in inflation and industrial output, the possibility of a rate rise by the US Federal Reserve will make it much more challenging for the central bank to cut rates at a faster pace. So far, India has attracted over $20 billion in the debt segment, thanks to the rate differential.

If RBI starts cutting rates and the US Fed raises rates, it might lead to some capital flows exiting India. This might accelerate if the rupee depreciates. A stronger dollar, as a result of the rising rates, will complicate matters further. Striking a delicate balance next year will be tough for RBI. As such, Dhananjay Sinha of Emkay Global does not expect more than a 50-basis-point rate cut through 2015.

But through the long term, RBI will have to allow the rupee to depreciate, as this is good for the economy. Eventually, if the cumulative misalignment between the rupee-dollar and the REER is very large, there will be sharper depreciation. A sharp depreciation in the currency impacts the profitability of Nifty companies. On a year-on-year basis, the beneficial impact of a weak currency faded in the second quarter of FY15, which dragged down revenue and profit growth of Nifty companies. According to Credit Suisse, the competitiveness impact will appear in time, even as the one-off impact is already visible — Indian pharma companies (3-17 per cent of sales in emerging economies, with weakening currencies) are likely to be adversely impacted, as are auto exporters.