Rupee - Dollar nightly update - Gold regains strength

Capital inflows could see a surge

In continuation of a theme which was at play last month, stability would reign supreme in the local currency market this week, too. The rupee-dollar pair would thus continue to trade within a range of 40.60 - 41.00.

Appreciation pressures would, however, be strong. Capital inflows are likely to see an upsurge. That is mainly because one of largest public equity offerings, made in June, is likely to see allotment money coming in from the foreign investors.

Even otherwise, general environment in global markets remains bullish and investors are willing to take on greater risk in return for higher yields.

In fact, after a shake-out in the appetite for risky assets early last week, investors were lapping up these assets again towards the end of the week. This appetite for risk would spill over to local assets, especially equities, and that would be a sentiment booster for the rupee, too.

The outlook for capital inflows in general is also quite positive. This bright outlook was reinforced last week when the RBI’s balance of payments (BOP) statistics for the last fiscal year, FY07, showed that the Indian economy received a net amount of $36.6 billion through capital and trade related inflows.

To put this number in perspective, the FY07 BOP surplus was more than twice as large compared with the surplus of $15.1 billion in FY06. Such a deluge was made possible by a surge in non-portfolio capital inflows, especially external commercial borrowings and FDI.

This not only attests India’s attraction as an investment destination, but also her greater integration with the global economy and capital markets.

Asian stocks may extend their rebound in coming sessions with Japanese exporters buoyed by a weak yen, but investors are likely to grow more wary as the quarterly corporate-reporting season looms.

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Fundamentally though, analysts say there is little to worry about given robust economic and earnings growth and a strong flow of money in regional markets.

"High valuations shouldn't be a concern as long as growth prospects don't fade and there aren't any negative surprises," said HSBC pan-Asian equity strategist Garry Evans.

The MSCI measure of Asian stocks excluding Japan has put on about 16 percent in the first half of the year, after having reached a record high June 22. This followed a 29 percent rally last year. It trades at 14.5 times forward earnings, the highest since 2000.

Tokyo awaits tankan data All eyes are on the Bank of Japan's quarterly tankan survey of business confidence due before the start of trade today.

"The thing that everyone will be looking at is capital spending," said Hiroyuki Nakai, chief strategist at Tokai Tokyo Securities, adding a strong result would be a plus for stocks.

Shares of exporters are likely to remain a focus for investors, buoyed by expectations of higher profits due to the weaker yen, said Nakai.

Curbs may cut Seoul gains South Korean shares are likely to rebound this week but gains are seen limited by ongoing worries about government action to curb margin trading.

"A technical rebound will continue," said Shim Jae Youb, strategist of Meritz Securities. "But continued foreign selling and the stronger won will cap the gains, with worries about a cut in margin trade dragging on following government officials' warning about margin trading."

Sydney searches for clues Australian shares are seen trading sideways as investors struggle to find trading leads ahead of the company-reporting season which kicks in around next month.

"I'd expect the market to continue to be volatile, but the overall trend will be flat running into the reporting season," said Guy Hutchings, chief investment officer at MFS Investment. "There's no economic data coming out that is going to be significant and I'd expect it to continue well into July until we start getting a flow of information that impacts people's view on the market and valuations of specific stocks."

Taipei likely to pull back Shares are likely to struggle to make further headway after reaching levels not seen since 2000, with renewed worries that the financial sector will not see a major improvement in earnings likely to weigh on some bank stocks.

"Taiwan shares would pull back briefly next week from seven-year closing highs, as investors wait to see if foreign investors continue to favor Taiwan stocks over peers in Asia," said Andrew Wang of Prudential Financial.

Southeast Asia cautious Investors will remain cautious, closely watching for the next move by China's central bank to tighten liquidity and with an eye on the Federal Reserve, which left US interest rates steady at its meeting last week.

Mark Matthews, chief Asia strategist at Merrill Lynch, said the short- term correction in Asian markets could encourage investors to reenter the market.

Why the rupee surged in the past few months is very clear. India has been the recipient of high capital inflows, Foreign Direct as well as Institutional Investment (FDI/FII).

However, what clearly stands out is the high External Commercial Borrowing (ECB) by Indian companies. ECBs have been on the rise recently as companies take advantage of the recent rule changes by the Reserve Bank of India permitting companies to raise more money abroad.

This works well for companies because they pay less interest compared to they would if they borrowed in rupees.

That said, while the general appreciation against the yen, the euro, and the pound can to an extent be explained by ECBs and FII/FDI flows, the situation against the dollar is a tad different.

The dollar has been on its own slump against most currencies because of recent issues with its economy, such as the general slowdown, the high interest rates, the problems in the sub-prime loan industry, and the high current account deficit.

However, one of the biggest reasons for the slump of the dollar is the bad news that is coming out the Asian countries especially those with large foreign exchange reserves, in particular, China.

This had the effect of keeping the value of the dollar high whilst keeping the interest rates low.

Now countries want to diversify their holdings of reserves and recently China said it wants to diversify the reserve holdings. Whether it will really diversify is not known but its mere mentioning of the fact had the effect of knocking the dollar fairly hard.

In theory, this deficit should have led to a fall in the dollar but it didn’t because the Asian countries hoarding reserves were doing so in dollars and this supported that currency’s price.

This huge deficit (most of it trade deficit) has increased the vulnerability of the dollar primarily because its future has become unpredictable.

The Impact of a Strong Rupee

The whole concept of outsourcing to India is the cost arbitrage that foreign companies get. The value of the contract will rise just because of the rupee appreciates and the Indian software companies have to take the hit for this rise.

Software companies have already given profit warnings post the steep appreciation of the rupee. On exports, it is going to have a fairly huge impact. Industries such as tea are already complaining about the effects that a strong rupee is having on tea exports. The REER of India against six countries as well as 36 countries (data for the first set are available until May 2007 and for the second until March 2007). show that with regard to the 36 countries the rupee is just overvalued, the six-country REER shows the rupee to be heavily overvalued. What this overvaluation means is that India has become uncompetitive and that goods from India are not price competitive vis-À-vis other countries.

When a currency appreciates, it more or less hits the trade balance.

India’s trade balance and the exchange rate on a monthly basis between January 2006 and April 2007 show that as the rupee appreciated, the trade deficit increased a month or so later. This lag is because foreign importers need time to react to the exchange rate. In April 2007 there has been a sharp rise in the trade deficit, a casualty of the exchange rate appreciation in March.

The Deficit Relation

With regard to the relationship between exchange rates and trade deficits, as the rupee weakened from 2000 to 2003, there was a general reduction in the trade deficit as a percentage of GDP. However, as the rupee strengthened, the trade deficits as a percentage of GDP start to get higher. 2007 is an anomaly but that was due to two reasons. One was high oil prices because of which the import bill was much higher than usual and the second was that production was at near full capacity and the only way to satisfy demand was to import.

Though much has been made in the media that a stronger rupee reduces the level of inflation since imported goods become cheaper, it is mostly a fallacy. This strong currency reducing inflation (also called ‘import led inflation’) works well in small open economies and India is neither. A strong rupee does initially have the effect of reducing the trade deficit but over a few months, exports usually get hit and imports boom because it is cheap to buy from abroad.

As this continues and the trade deficit gets higher, the rupee starts to depreciate because there is now increased demand for the foreign currency and it is back to Square One. Then what happens is that the weaker rupee will actually bring in inflation. Though the rupee is currently being supported on the back of very strong capital inflows, one must also note that most of those inflows are those that will also one day leave the country (ECBs and FII).

Where is the Indian Rupee Headed?

However, any forecast of beyond a year should be taken with a grain of salt. A forecast of the rupee is something that falls into that category as there is no standard quantitative model to forecast the rupee movement and most forecasts of the rupee are qualitative judgments.

My view on the rupee is fairly similar to the above. In the near-term, it should be in the 41.50-42 range. The reason is that the rupee gets heavily influenced by FII inflows. FIIs (hedge funds) are bringing in big sums because of the property market and Initial Public Offers by Indian corporates as well as the booming stock market. However, most of this money is short-term and will go out of the country fairly soon especially as stock market and real-estate valuations in India are generally thought to be in the expensive and over-valued.

The rupee, in my view, will start appreciating again in around 18 months because FDI money into infrastructure projects will start coming in and this money is going to be fairly large. However, it is unlikely to appreciate beyond the Rs 38 levels because the RBI will still view rupee appreciation as something that will affect the economy as it can hit the software and the export sectors fairly heavily.

What the past few months have shown is that a currency that is managed just does not work in the long term. It gives the illusion of being a panacea but in effect only pushes problems into the future. The gist is that the rupee needs to be left to market forces. They may be some volatility in the beginning but then it usually will sort itself out.

The RBI may have been a decent manager of the currency before but that was when capital flows were at a minimum. It would be fair to say that central banks are often out of their depth in this era of modern capital flows.

The only way out of this predicament is to free the rupee and for the country to adapt itself to a free floating rupee as the costs of managing the rupee will soon outweigh any benefits.

"Asian [mutual] funds have underperformed Asian markets because I believe they are `underweight' China," he said. "Any weakness will be a buying opportunity for them in China."

Mumbai milestone seen Indian shares may rise to new highs as investors prepare for quarterly earnings from frontline companies, which will start reporting in the second week of this month."The market has been very stubborn in making a new high in the past few sessions, but I think it is poised to cross that milestone in the coming week," said Jayant Pai, vice president of equity sales at Parag Parikh Financial Advisory Services.

Export-driven Indian software firms, which earn about 60 percent of their revenue from overseas, have come under pressure on worries the strength in the rupee against the US Dollar would hurt their earnings.

After data Friday showed annual inflation falling to a 14-month low of 4.03 percent, the benchmark Sensex rose to within 80 points of its record high of 14,723.88, set in February. Before that, the index has to breach resistance at its June 4 high of 14,683.36.