Why The Rupee Will Weaken
The rupee has started to gradually move into a lower band in the forex market. It dipped sharply below Rs 44 to the US dollar a fortnight ago and, despite an apparent recovery is still showing a downtrend. This is to be expected, for several reasons.
The simplest cause of pressure on the rupee is divergent interest rate trends in the Indian economy versus the American. India has high real interest rates. But they are coming down rapidly. This is so partly because the RBI has done its level best to "talk" rates down with a cut in the bank rate and also increased money supply with cuts in SLR requirement and reporting requirements. But real interest rates are coming down because inflation is starting to rise rather more rapidly than most people anticipated. With a poor monsoon predicted, this trend will continue for the next several months.
In contrast, America has a trend of rising interest rates. Inflation is also starting to rear its ugly head in the US economy, which frankly looks on the verge of over-heating. The Federal Reserve has responded with a sequence of interest rate hikes over the last six quarters and promises to deliver more of the same medicine in the near future.
Given the divergence, the rupee must move down to balance the arbitrage situation. Otherwise, rupees can be converted into dollars, earn higher American rates of interest and be converted back into rupees with a risk-free gain. If the trend of divergence increases, the rupee drops further.
There is another compelling macro-economic reason to expect the RBI to encourage a rupee decline. The government has to raise roughly Rs 4,500-5,000 crore per fortnight in borrowings to meet its projected deficit. Now that will impact money supply if it is an "unsterilised borrowing", to coin a phrase.
The RBI must do something to maintain money supply at around current levels despite the enforced borrowing. There are two ways to do this. One is simply to print notes but monetisation is not politically correct. In any case, monetisation will also result in a prompt run on the rupee.
The other option is to release rupees into the market against the purchase of dollars to balance the rupees borrowed to finance debt. This, in effect, turns the borrowing programme into a "sterilised" intervention. Dollars are bought, rupees sold and simultaneously sucked back out of circulation as debt.
Money supply would be maintained, so would interest rates. But what happens to the exchange rate if the RBI buys Rs 4,500 crore worth of dollars every fortnight? Supply and demand will push the rupee down. I'm sure RBI governor Bimal Jalan understands this far better than you or me. But what choices does he have? Reserves could swell past the $60 billion mark if the trend is carried to a logical conclusion.
What happens with a weaker rupee? Domestic industry gets extra protection. Exporters do better. Whether a lower rupee is enough to keep Indian exporters competitive versus a resurgent East Asia is anyone's guess. For that matter, the dropping Euro may make the EEU a major export engine. Let's hope that the pros outweigh the cons, for a rupee decline seems inevitable.