Rupee outlook: India ready for capital inflow

Last Updated: Tue, Jun 03, 2014 04:32 hrs

The rupee has risen 15 per cent against the dollar, compared to 68.8/dollar in August, mainly due to an improvement in balance of payments, an inflation-targeting framework, rise in external confidence, the US Federal Reserve's forecast on neutralising tapering effects, the rupee's status as a high-carry currency in attracting flows, and the results of the Lok Sabha elections.

In the near term, pressure on the rupee will rise as the investment cycle picks up. Given the balance-sheet expansion in Japan and an improving growth outlook in India, the yen carry trade may be used to finance the investment cycle. In the last few years, given the rupee's fall, exporters had reduced hedge ratios, while importers were increasing theirs. With the change in the outlook, importers will cover exposures on a cash basis, while exporters will try to realise forward premia. This will change the leads-lags position and benefit the rupee. A robust divestment/auction programme will augment foreign direct investment and external borrowings.

But the central bank is expected to temper the move, as the rupee is fairly valued from a real-effective-exchange-rate perspective. The bank is expected to build reserves so the source of primary liquidity creation is backed by forex reserves. Savings, disintermediated, should get re-intermediated by the banking system; this should help finance the investment cycle. As capacity comes on stream, the disinflationary process should accelerate. If this plays out, the bank will be emboldened to reduce its intervention response.

From a longer-term perspective, bottoming out of the economy, with a stable government committed to fiscal consolidation and a fall in inflation, and we have the ingredients for a long-term bull market. We could be at the cusp of asset re-allocation from long-term investors.

The road map for rupee reform is: One, stabilisation: An improvement in the current account. Two, structural: India should orient itself as a manufacturing hub, taking China's place. Real, rather than nominal undervaluation, should be an element of this strategy.

The rupee's outlook has turned positive from tactical and strategic perspectives.

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