Rupee Forex directional analysis

India’s accelerated economic growth is more of structural in nature than a cyclical one. The growth has been buoyed by market liberalisation and technological advancement in the services as well as manufacturing sector.

This is according to the US-based investment banker Lehman Brothers, which has been showing significant business interest on India’s developing economy.

India’s gross domestic product (GDP) grew by 9.4% for 2006-07, higher than the expected 9.2% growth. The average growth for the past four years has clocked as high as 8.6%.

“This does not look like a flash in the pan. India’s low-cost economy is reaping the rewards of market liberalisation; Indian companies (initially in services, but now also in manufacturing) are seizing the opportunities presented by new technologies and a more open economy,” the investment bank said in its latest global report.

The company believes the economy will sustain 9-10% growth in the medium term. “Given that India’s GDP per capita is just $790, nearly three-fifths of its workforce is still in the countryside and half its population is under 25 years old, there is still much growth potential to be unlocked. The key is more supply-side reforms without politics getting in the way,” it said.

India’s gross domestic investment as a share of GDP jumped from 33.8% in 2005-06 to an estimated 35.1% in 2006-07. “It is set to climb further. Robust government revenue is providing room for infrastructure spending,” the report said.

Lehman Brothers is, however, of the view that the high bank credit growth may be cyclical in nature. “The economy is facing some strains. WPI inflation has remained firm and credit is growing at twice as fast as nominal GDP, suggesting that some of the growth acceleration could be cyclical,” it said.

On the forex management front, it said: “We expect the RBI to take a middle-road approach: managing the pace of rupee appreciation, while working hard to mop up liquidity by heavily utilizing the CRR and open market operations.”
In the last few months Indian Rupee has appreciated against the US Dollar. This has taken place despite India's adverse balance of trade with the US and a higher rate of inflation in India. India however has raised interest rates significantly to control inflation. The reasons is that demand for Indian Rupees from foreign investors buying Indian Rupees in exchange for US dollars has been rising and strong.But this is a normal phenomenon. When foreign investors perceive better prospects for investing in a country and rush into invest they raise the demand for the local currency relative to the foreighn currency. This may also be accentuated by speculative buying of local currency. But it is not clear what special lesson can the US learn from this or find an answer to any exchange rate problem.
Any study of exchange rate movements relating US dollars and Indian Rupees is welcome. But the explanatory variable have to be carefully selected.

The Indian rupee has been experiencing significant movement in the recent past. It is affecting the interest of both importers and exporters. With the economy and trade growing and Indian economy being increasingly linked to the world economy, such volatilities are exposing the participants to currency risks.

In such a scenario, it is necessary to have an independent currency derivatives exchange so as to enable all importers and exporters to manage effectively currency risks even while doing business. In this context, it is imperative to examine the nitty-gritty of setting up a Currency Derivatives Exchange under the existing regulatory frame-work.

Currently the Indian rupee is not fully convertible on capital account and there are restrictions on remittances of foreign currency funds in and out of India. The RBI, through FEMA, regulates the entire flow of foreign currency. Therefore, it is important to examine the modalities of setting up a currency derivatives exchange:

1. Without changing any of the existing regulatory framework;

2. Without making the rupee fully convertible; and,

3. Without necessarily liberalising the process of remittance of funds.

In order to achieve these objectives, the contracts should be traded only in India and there should be no foreign participation or remittance of funds outside the country through this contract as the rupee is not fully convertible. Otherwise, it becomes a de facto conversion.

These contracts can be cash-settled as per the RBI reference rate on the maturity date or if these are delivery based, then outstanding positions on maturity are to be settled by delivery of dollars. Receipts and delivery of dollars must happen only in India, electronically through bank transfers, and banks should comply with all the RBI norms relating to the delivery of dollars by their clients.

In the present structure there are three markets governed by three different regulatory bodies. The Sebi regulates the securities and stock markets under Securities Contracts Regulation Act, 1956. It regulates both spot and futures markets. Futures trading in commodities are regulated under Forwards Contracts Regulation Act, 1952 by FMC. And the RBI regulates the entire forex market.

Foreign currency markets are very sensitive. Any complication in this market might lead to a very serious consequence and affect severely exports, imports, balance of trade, balance of payments and our competitiveness in global trade. Any wild fluctuations in the forex market are more severe than any price fluctuations in stock or commodity markets.