The freefall in the rupee has been arrested but don’t expect a full recovery this year

(20 January 2012) — The worst is over for the rupee after India’s central bank injected more than US$4 billion over three months in late 2011 to arrest the currency’s freefall, which was triggered by global risk aversion as investors started to pull funds out of India.

The Reserve Bank of India sold US$2.9 billion in November alone, the month that saw the rupee tumbling nearly 7%, its worst fall in 16 years, to hit a record low of 52.40 rupees to the dollar.

The November dollar sale was a massive increase from the US$845 million and US$943 million sold in September and October respectively, according to the central bank’s latest bulletin on January 12. This was also the highest quantum of sales in 32 months.

The significant intervention by the central bank is contrary to popular belief that it was following a hands-off approach. Experts close to the bank believe that the intervention had actually become necessary.

“Ideally the market forces should drive the exchange rate and there should be minimum interference (from either the the central bank or the government). However, when the exchange rate reaches a juncture where it starts causing distortions to the general economy, it should be addressed,” Madan Sabnavis, chief economist at Credit Analysis & Research Limited, India’s second-largest credit rating agency, told Asia360 News.

That juncture arrived in 2011 when the rupee, the worst-performing Asian currency, lost more than the 19% of its value against the US dollar between August and November. The loss was equivalent to the rupee’s total depreciation in the 2008-9 global financial meltdown.

On top of selling dollars, the central bank put in place measures to monitor the daily positions of banks and the purpose for which they were buying currencies. To curb speculation, it curtailed by as much as 75% the overnight limits for banks, which is the maximum amount of currency positions that can be carried over to the next trading day. The authority also banned the cancellation and rebooking of forward contracts, which allows the purchase and sale of an asset at a specified future time at an agreed price.

Within three weeks over October-November 2011, India’s foreign exchange reserves fell by US$12 billion, the steepest drop since the Lehman Brothers collapse in 2008. The massive depletion was a fifth of the $65 billion that India lost during the entire 2008-9 financial crisis.

“Rupee woes began with the eurozone crisis causing a dollar liquidity squeeze in the Indian markets both on the debt and equity capital markets. During this time, importers stayed uncovered on future dollar payables while exporters stayed fully covered on future receivables; thus setting the market in a heavily dollar oversold position. It was one-way street with excessive dollar demand and very limited supply,” Moses Harding, head of economic and market research at IndusInd Bank told Asia360 News.

The Indian economy was also beset by low growth, high inflation, tight liquidity, high interest rates, high fiscal deficit, and a big trade gap.

“It is difficult to defend currency weakness when the investment inflow into debt/equity capital account is not adequate to bridge the current account gap. In a way, India was exposed of its dependence on external liquidity to ensure exchange rate stability,” Harding said.

The mass pull-out of funds from India left the country’s foreign institutional investor inflow at almost zero in net terms for 2011, against nearly US$30 billion annually in the past.

To push foreign investment, the Indian government decided in November to raise foreign investment limits by $5 billion each for government and corporate bonds, to reach $15 billion and $20 billion respectively. The window for the raised limits ended on January 13.

Improved market sentiment this year has helped the rupee recover somewhat. A furious bout of trading in the final hours of January 13 sent the Indian currency to a five-week high of 51.29 rupees to US$1, ending the day at 51.53 to the dollar. The general improvement in global risk sentiment contributed to the dollar inflow in January, as did steps by the Indian government in December to re-invigorate the economy. The government liberalised the single-brand retail sector (a similar decision on multi-brand retail had to be put on the backburner amid political furore) and deregulated the interest rate on non-resident bank deposits.

However, many experts believe that the rupee may not make a full recovery in 2012 to return to the pre-fall levels of July 2011.

“Rupee fundamentals continue to stay weak. The economic dynamics has shifted from moderate growth and high inflation to low growth and moderate inflation. The resultant shift of monetary stance from anti-inflation to pro-growth will add to pressure on rupee,” Harding said.


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