The latest decision by the US Fed's outgoing chairman, Ben Bernanke, to reduce bond buying by $10 billion to $65 billion in February has put the spotlight back on emerging market currencies in general and the rupee in particular. Most emerging market currencies and stock indices reacted negatively to the Fed tapering, with the Indian currency falling 1.7 per cent from the highs of January. Stock markets have fared worse, with the benchmark NSE Nifty dropping four per cent during the month so far.
The biggest worry for the Indian currency is a likely capital outflow from India as foreign investors adjust their global portfolio in the face of a cut in the bond-buying programme, known as quantitative easing (QE). When news about the tapering first broke in May 2013, it had triggered a big sell-off on Dalal Street and the rupee had hit a new low as foreign institutional investors (FIIs) moved to cut their exposure to India in favour of the safety of the US. By the end of August, the rupee had lost nearly a quarter of its value against the dollar and the benchmark Nifty contracted 13 per cent during the period.
Some analysts expect a repeat of this, as FIIs are as wary of India's macroeconomic risks now as in May last year. The resulting capital outflow is likely to keep the rupee on a depreciating trajectory. "In the last three years, a big divergence has emerged between Index of Industrial Production (IIP) and capital inflows. While IIP is growing in low, single digits, the capital inflows were as high as 4.5 per cent of the GDP, indicating over-allocation to India by foreign investors due to QE. As capital gets expensive and less plentiful, FIIs will cut their exposure and the rupee is likely to depreciate further," says Dhananjay Sinha, co-head (institutional research) at Emkay Global Financial services. He expects the rupee to breach the 63-a-dollar mark by end-March and 66 by the end of 2014 (calendar year).
Another worry for the rupee is the continued inflation differential between India and key trading partners such as the US, the UK, European Union, China and Japan. According to a recent report by Emkay Global, the cost of living in India (relative to the top six trading partners) as measured by Consumer Price Inflation (CPI) is up 80 per cent since 2004, against 36 per cent depreciation in the rupee during the period. "Cumulative inflation differential has become large despite recent depreciation and it will correct sooner or later," says Sinha.
Others, however, differ pointing at the recent improvement in current account deficit and continued capital inflows. FIIs invested $110 million in Indian equities in January on top of nearly $20 billion in 2013 (calendar year). "With the fall in imports and better-than-expected growth in merchandise and services exports, India is now less as vulnerable to sudden capital outflow than six months ago. Last year, India was an outlier on the negative side among key emerging markets. This year, we expect India to be an outlier on the positive side," says Devendra Pant, chief economist and head (public finance) at India Ratings. He expects the rupee to stabilise at 58-60 a dollar by March this year.
The view is echoed by Motilal Oswal Financial Services. "The rupee has already depreciated in line with other emerging market currencies and we don't see any downside from here on till the new government takes oath in May this year. After that, the rupee's fortunes will depend on the composition and the economic policies of the new government," says Kishore Narne, head (commodity) at Motilal Oswal.
Jamal Mecklai of Mecklai Financial is keeping his fingers crossed, given the emerging political uncertainty. "We are not in a very comfortable position, economically and politically. This rules out rupee appreciation but there is not likely to be a big-bang depreciation of 2013 either, given the interest rate rise by the Reserve Bank and the resilience shown by the rupee in recent weeks," he says.
Given the market's fractured verdict on the rupee, analysts are advising investors to hedge their equity portfolio by raising exposure to export-driven sectors such as information technology and pharma.