Waiting for US Fed action

RBI faces the problem of keeping the rupee stronger to import energy but not strong enough to hurt exports

The coming week is likely to see the onset of a new wave of currency volatility. Decisions taken at the US Federal Open Markets Committee (FOMC)'s policy meeting might set new directions or intensify ongoing trends, which will affect the rupee and other currencies. India has always been integrated with the global economy, due to its very high dependency on energy imports. In percentage terms, trade, meaning physical exports and imports, accounts for a larger portion of India's gross domestic product (GDP) than it does of China's GDP. The isolationist policy of the pre-1991 era was stupid because it ignored the necessity of crude and gas imports.

Energy imports rise in tandem with economic growth. In addition, some percentage of household savings always fuels gold imports. Since energy and gold imports will not fall below a certain point, India must generate exports to maintain a reasonable trade balance. RBI has to keep the rupee stronger enough to ensure India can afford to import the energy it needs; RBI must also keep the rupee weak enough to ensure exports stay competitive. In addition, there is external, forex-denominated debt amounting to about 30 per cent of GDP, which must be serviced.

FOMC has several possibilities, in theory. A cut in dollar rates is near-impossible, given interest rates at near zero. The Fed could, in theory, unleash another round of quantitative easing (QE), though this seems very unlikely. We can safely ignore the possibility.

The Fed could hold policy rates at current level and not change money supply. That is now the consensus expectation. Or it could raise policy rates. Either course would lead to a stronger dollar but a rise will cause a sharper move. Yields in US treasuries will rise on a rate hike. That will attract higher inflows and accentuate the dollar hardening.

The dollar is likely to appreciate anyhow against most currencies, for several reasons. There is already a trend of weakness versus the dollar. There is capital flight to dollar assets, given weakness in China and other emerging markets.

The yen is weak due to an ongoing QE programme. The euro also has an ongoing QE, and remains weak. China recently devalued the yuan. It is likely that Malaysia, Indonesia, Taiwan and South Korea will all do devaluations, as these export-oriented economies need to maintain competitiveness.

India faces competitiveness issues. Exports have declined for nine months in a row. The rupee has weakened recently due to foreign institutional investors (FIIs) pulling out of the Indian markets after the Chinese devaluation. This weakness might not be enough to stimulate exports. Also, the domestic economy could face competition from cheap imports. A weaker rupee would help with both the protection of the domestic economy and export competitiveness. RBI's real effective exchange rate (REER) calculations compare the rupee against a trade-weighted basket of 36 currencies. REER indicates the rupee is over-valued. India's exports are expensive and imports into India are relatively cheap.

RBI must be tempted to let the rupee slide lower so long as it can control the velocity and volatility of decline. Apart from allowing rupee to be sold down in forex markets, the RBI could also cut the policy repurchase rate which would have a weakening effect.

But the ideal trading range will depend on the Fed's action. Another way of looking at this is via interest rate differentials. RBI has to decide what the ideal difference between interest rates should be. If the Fed does hike, the interest rate differential between the dollar and the rupee narrows. That means rupee is weakening. If the Fed holds rates, RBI might cut rates to narrow the difference.

Currently, a currency depreciation would not expose the economy to danger. Essential imports like crude oil and gas are cheap, and might get cheaper in dollar terms, balancing off a weaker rupee. Gold has also seen a deep correction. Other commodities are also cheap. Obviously, companies holding foreign exchanges debt, and net importers will be under pressure if the rupee falls. That is balanced off by more competitive conditions for physical exporters and for the service sector.

Apart from information technology and pharmaceuticals, a serious devaluation could help spark turnarounds for physical exporters in areas such as textiles, jewellery, machinery and automobile ancillaries. The positive aspects of a weaker rupee should far outweigh the negative aspects for the Indian economy as a whole. From an investor's perspective, the rupee is very likely to continue weakening anyway. That will change sector-specific outlooks as well as the outlook for individual companies.