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Decimal Digest
28 Nov 2011

Indian Rupee: Fear not, cheer the fall!

Many market participants are suprised, and are rueing the recent dramatic fall in the Indian Rupee. Suddenly, everybody seems to have woken up to the persistent current account deficits of India, and increasing reliance on short term debt for financing the same.

We postulate here that, on a fundamental basis, the Indian Rupee has fallen as much as it would have in more serene times. Let’s look at the chart below:

The recent fall has removed virtually all the overvaluation of Rupee, with REER now close to 100. On a fundamental, basis, this is a good enough depreciation.

However, domestic politics in India is such that it is not going to be easy for the government to control fiscal deficit within meaningful bounds, leading to persistence of a substantial current account deficit for some time to come. Also, the investment sentiment is so badly hurt in India, that the recent reform of opening the retail sector to FDI will take considerable time to materialize in significant value on the ground, which could meaningfully change the capital account.

All of us can appreciate that these are not normal times. The overleveraged European banks are in a deleveraging mode, and are disgorging assets across the world, causing valuations and flows to depart from the recent historical trend.

As long as this deleveraging trend continues, India will find it increasingly difficult to fund its excessive current account deficit on reasonable terms. The RBI is facing a Hobsonian choice of either rapidly runing down the forex reserves or allowing a rapid fall in the rupee. Both the options have strong negative implications for the real economy, and also on the expectations of market players.

We believe that the result will be a very weak INR. The technical flow factors can take REER for the Rupee to as low as 85. India has seen such REER levels in the early 1990s, and so they are not totally out of line with historical evidence. If India experiences a level of 85 on REER by late 2012, this would imply the USDINR of 60. Readers may note that this prediction is based on continued deleveraging in Europe. If the ECB starts its printing presses, the picture could be different.

The depreciation could be good news for India, in competing against China in the global market place. In the last five years, Indian currency has depreciated by 12%, in real terms, against CNY, and there is a prospect of another 10% depreciation in the forseeable future.

This could give a strong competitive advantage to India, over the medium to long term, provided the Indian government can get its act together on structural reforms and critical infrastructure.


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