A strong rupee: What’s powering it?

At the end of March quarter this year, the Indian rupee ranked third in terms of performance in Asia, trailing the South Korean won and Taiwanese dollar. This was a result of its steady gain against the US dollar in the first couple of months of the year. It continues to retain its strengthened value till date by hovering around 64.50 per dollar. From about 68 per dollar in December, it has appreciated almost 5.5 percent over the months.

The turnaround in the value has been rather unprecedented for experts had predicted it to depreciate further to 70 per dollar. However, if one considers the strengthening economic fundamentals of the nation and other macro-economic factors, the uninterrupted rally has been par for the course. Here’s how…

Favourable macro-economic factors fanning rally

The massive surge in foreign portfolio investments (FPI), which are investments by overseas investors into both Indian debt and equity, is said to be primarily powering the rupee. The logic is simple: In order to invest in Indian securities foreign investors need to buy the Indian currency and this has driven up its demand substantially in the past couple of months. The demand, in turn, has strengthened its value. In fact, massive outflows of FPI came down drastically in January 2017 and currently the nation is witnessing net inflows worth billions in both debt and equity. It is said that over $13 billion has flowed into the nation’s market since the beginning of the year.

And what could have been the possible trigger for such a drastic change? The answer lies in the nation’s improving global profile brought about by a growth focussed Modi-led BJP government at the centre. Ever since coming to power the government has taken several measures to put the nation on a growth trajectory. Some such measures are further upping the limit of foreign direct investment (FDI) in various sectors (cent percent in many), improving transparency and pushing ahead with the ambitious Goods and Services Tax (GST) to simplify the tax structure in the country and improve ease of doing business.

The BJP government’s win in March 2017 state elections in Uttar Pradesh, for example, reassured investors further that reforms would continue in the right direction. This buoyed markets, thereby bolstering the rupee by almost 3 percent.

Other macro-economic factors have also provided tailwinds. The most prominent among them has been the sustained weakness in oil prices. For India, which imports most of its oil, reduced prices translate as lesser dollar demand as oil has to be purchased using the greenback. This has underpinned the rupee’s rally further.

The increasing of the interest rate by the US Federal Reserve on March 15 by 25 basis points (one basis point is equivalent to 0.01%) also helped the rupee notch gains. Normally, a rate hike results in a stronger dollar as it tempts investors to park money in US assets owing to higher interest rates. But this time around the hike was not in line with investors’ expectations of a more hawkish stance against the backdrop of a firming US economy. Hence, the dollar slipped and investors flew to emerging markets strengthening their currencies. The Indian rupee was no exception and gained too.

The most dramatic boost to the rupee, so far, however, has been provided by the Reserve Bank of India’s (RBI) decision to increase the reverse repo rate, which is the rate banks are offered for depositing their excess cash with the central bank. The move was intended to suck out the excess liquidity in the banking system ensuing from the government’s decision to ban high value notes in December through demonetization. The RBI’s move resulted in a rise in bond yields which lured more FPIs to invest in them. The rupee value received a major fillip from it and saw its biggest gain in 20 months.

Rupee rally good or bad?

Having glanced at the reasons that have bolstered the rupee, the next big question that begs an answer is if it bodes well for the economy. The answer is simple – a strong currency is good for the import sector and bad for export sector. But India being a net overall importer will likely benefit as it will bring down cost of buying. The aviation and select consumer durables companies will gain most as they import crude oil or crude oil derivatives.

Inflation, of course, will be bridled with a stronger rupee as India’s major imports, namely oil, gold and jewellery and electronics will cost less. Reduction in production costs for firms with petroleum-based primary input will also reign in prices.

The strength of the rupee, on the flip side, can also slam the brakes on the export sector struggling to revive. Automobile and ancillaries, textile and pharmaceutical companies will likely bear the maximum brunt as a stronger currency will dent their export earnings significantly. The mighty software sector, considered the nation’s growth engine, will also be hit as it earns its revenue in dollars mostly.

Small and mid-sized export oriented companies will see their profits eroded while cheaper Chinese electronic and other consumer goods’ sales will surge in India. Eventually, with narrower margins companies might be forced to cut costs by downsizing labour force or even shutting down units. All these could negatively impact the nation’s GDP growth in the foreseeable future.

So far, the RBI concerned more with tackling liquidity has not taken any strong steps to check the rupee’s unbridled rise. But with gold buying seeing an uptick around late April and May coupled with more rate hikes in the US, some of the Indian currency’s gain may be reversed sometime in the near future.