Strong outlook for rupee

As yield differentials rise, analysts expect higher dollar inflows into debt, equities

Forty years ago, John Connally, Secretary of the US Treasury, reportedly said to a delegation of Europeans worried about exchange rate fluctuations, “The American dollar is our currency, but your problem.” Evidently, the dollar (the world's reserve currency) continues to be a problem.

If all things are equal and the downgrade was to happen to any other country, then the assets (treasuries) of this country should be worth less, right? No. The greenback is still the world’s reserve currency and so the downgrade hasn't impacted US assets as such. As talk of a third round of quantitative easing gathers pace, the outlook for the dollar looks weak, as any further bond buying programme will pump more dollars in the system.

So, the dollar strengthening after the downgrade is but a temporary phenomenon. The euro, too, is in trouble, which was some kind of an alternative to the dollar. With both the dollar and euro in trouble, Asian currencies are expected to strengthen this year. Priyanka Kishore of Standard Chartered says: “We are raising our short-term FX rating on the Indian rupee to overweight from neutral.” The rupee is expected to close the financial year at 43 against the dollar, compared to the earlier expectation of 44.

Analysts believe the rupee is likely to benefit from high yield differentials and more dollars are expected to flow into the country in search of better returns. The influence of both short-term carry and forward rates expectations on the rupee have increased significantly since late 2010. This will improve portfolio flows into debt and equity. As inflows improve by the second half of this financial year, the rupee should start appreciating, too. Another big driver of the rupee appreciation is the foreign direct investment (FDI). The period of April-June has seen FDI inflows of $13 billion compared to $19 billion in FY11.

However, the rupee has not appreciated in line with other currencies in the region because other Asian countries have current and capital account surplus, India faces a deficit situation. Higher crude oil prices are reflected in the wider monthly trade deficit. Looking ahead, analysts don’t expect a significant widening in the trade deficit due to moderation in Brent prices, slowing non-oil imports and support to exports from China and the US. Together, these should cap the current account deficit-to-GDP ratio at 2.8 per cent, says Kishore. However, the immediate issue behind the rupee’s weakness is the $5-billion payout to Iran. In the short term, USD-INR could face some upward pressure due to a mild dollar shortage. However, with inflationary concerns prevalent, In the medium-term, according to HSBC Global, expect USD-INR to resume its downward trend.