The side-effects of a firm rupee

The rupee has gained 5.2 per cent versus the dollar since January, rising from ~68.23/dollar in early January to a current value of about ~64.65. At first glance, this makes little sense. The Federal Reserve has already hiked rates and signalled a willingness to hike again. Dollar bond market yields have therefore, risen.

At the same time, rupee yields have eased, with the Reserve Bank of India (RBI) holding the policy rate stable and tightening the spread between the Repo and Reverse Repo rates. Hence, US bond market investors can expect to receive higher yields while rupee debt investors receive stable or lower yields. Put it together and the dollar should get stronger, given higher riskfree returns.

But, portfolio flows are very much in favour of India. The rupee has risen mainly on the back of FPI (foreign portfolio investors) inflows, which amounted to an humongous net ~85,108 crore since January (~44,485 crore equity and ~40,624 crore debt).

Traders are expecting a snap back and bounce in the dollar. Some are betting on this with long dollar-rupee positions. The RBI could try to ease the rupee down by buying dollar. Also, the Fed is due to meet next in early May and if it does raise rates, or makes hawkish statements, the dollar may harden anyhow.

Beyond trader expectations, a strong rupee could have several negative consequences and some positive consequences over the current fiscal. The RBI surveys professional forecasters (PFs) regularly and 21 PFs were polled in March in the latest Survey. Some median expectations are given below.

The inflation indices, the WPI (wholesale price index) and the CPI (consumer price index) are expected to diverge in direction. The CPI is expected to rise through 2017-18, hitting 5.3 per cent year on year by Jan-Mar 2018. The WPI is expected to moderate from the current 6.55 per cent to about 3.7 per cent by January-March 2018.

Merchandise exports are expected to grow by 5.9 per cent (dollar terms) in 2017-18 over 2016-17. In 2016-17, exports are expected to grow by 2.8 per cent which is itself good news, given shrinking exports in two prior fiscals. Merchandise imports are expected to grow by 7.1 per cent in dollar terms. The Current Account Deficit is expected to rise to 1.2 per cent of GDP from 0.9 per cent in 2016-17.

Inflation and trade expectations could be affected by the rupee's trend. The rupee is now seriously overvalued going by RBI Real Effective Exchange Rate (REER) calculations. The REER for example, suggests that the rupee is about 17 per overvalued versus a 36-currency basket weighted according to trade. Other REER calculations with different currency baskets and different weights imply over-valuation of anywhere between 6-30 per cent.

Overvaluation impacts exports, which become less competitive. It impacts imports as well. A strong rupee makes imports cheaper, which means local merchandise also suffers in domestic trade. This can be countered to some extent by putting higher customs duties but that is not desirable.

We may therefore expect underperformance on the export front, coupled to higher imports if the rupee stays strong. The "Make in India" initiative could be hit, which means less job creation. On the positive side, inflation will probably be lower, unless domestic goods are over-protected by raising customs duties. Net importers like the oil majors, power generators, and corporates with outstanding overseas debt, or FCCBs, will be happy.

If the rupee-dollar exchange corrects back, there would be a lucrative long trade on the dollar. If the rupee stays strong or strengthens even more, there could be a downgrade of export-oriented stocks, coupled to an upgrade on corporates with overseas debt exposure. Lower inflation also implies that RBI would be more inclined to cut rates and that's a potential positive.