Lower interest rate for softer rupee

Hindustan Times, 20.10.2007

D. H. Pai Panandiker

In the last one year there has been an appreciable realignment of world currencies. The dollar has weakened against almost every currency, some more than others. The differences reflect the special circumstances as in Japan or measures taken by central banks to prevent the currency from appreciating too much as in China. The Indian rupee, like the Thai baht, hardened against the dollar more than even the euro.

Exchange rates depend essentially on the fundamentals of the economy influenced, in the short term, by the rate of interest. The fall of the dollar is associated with the slowing down of the US economy starting with the housing sector. The sub-prime mortgage crisis, followed by the cut in the interest rate by Federal Reserve, quickened the fall. If euro is taken as the reference currency, the depreciation of the dollar would be 11 per cent.

The movement in the exchange rate between the dollar and the rupee reflects partly the depreciation of the dollar and partly the appreciation of the rupee against the euro. The rupee excessively appreciated because of the increase in the rate of interest by the RBI. This attracted more funds from foreign investors, as also overseas borrowing by Indian companies, to take advantage of interest differentials. Consequently, the rupee was up 13 per cent against the dollar; the yuan only 5 per cent.

It is quite likely that the dollar will fall further because the US economy is on the verge of recession and the Federal Reserve may reduce the interest rate further to pep up demand. The European economy, on the contrary, is performing well but is not free from inflation bias. It is quite possible that the European Central Bank may increase the interest rate. That will enlarge the interest differential between the US and the EU and depreciate the dollar against the euro. Already, with the strong euro the ‘carry trade’ has revived and the yen is therefore more likely to weaken.

The funds flow from US will also flood the currency markets of Asian countries which have become favourite destinations for US investors. The rupee will appreciate against the dollar unless the RBI absorbs the excess dollars in the market. In the past one year the RBI added nearly $100 billion to its reserve kitty with liquidity being mopped up through a variety of monetary instruments. To avoid purchase of dollars for keeps the RBI, it appears, has recently been intervening in the forward market. It buys dollars spot to sell in the future. This can at best be a temporary solution.

In the next few months what is likely is the fall of the dollar against the euro and the fall of the yen against the dollar. The baht, yuan and other emerging market currencies may well stay put. The RBI has its own limitations about market intervention. But appreciation of the rupee against the dollar can be partly corrected if the interest rate is brought down.