The currency conundrum

MARKET INSIGHT

Between January and December 2007, the rupee appreciated over 10 per cent against the US$ and hit a ceiling at close to Rs 39.2/ $. In 2008, it has depreciated again, by about 8-9 per cent and gone below 42.75.

Both trends were anti-consensus. In early 2007, most observers were projecting that the rupee would depreciate, just as it zoomed. In early 2008, the rupee started weakening at a point when most people assumed it would continue to appreciate.

There are all sorts of macro-economic reasons for the way the rupee has behaved. The simplest explanation is, we assume that there is some causation associated with the strong correlation of rupee movements with portfolio inflows.

Through 2007, foreign institutional investors (FIIs) flooded India with cash, over $17 bn in net equity investments. That over-compensated for negative trade balances and rising Indian inflation. The rupee stayed high. In 2008, the FIIs have been net sellers of over $2.3 bn and the rupee has dropped.

Is it as simple as supply and demand? Portfolio investments (including hedge funds, debt and derivatives outstandings of FIIs) are the most volatile capital flows. Especially in a country lacking full convertibility, portfolio capital is the swing variable that shifts supply-demand equilibriums.

Of course, RBI has its say. But the central bank's hands are tied by political considerations. It's facing the impossible trinity dilemma