First World will attract more flows

One of the simplest ways to ‘value’ foreign exchange rates is by using the following calculation. First, compare risk-free interest rates of the same tenure in any two currencies. For example, the one-year treasury yield in rupees is 6.36 per cent and the one-year T-Bill yield in the US is 1.7 per cent.  

The Reserve Bank of India (RBI) reference rate on Thursday was Rs 64.28 per dollar. If you convert rupee to dollar at 64.28, invest in US Treasuries and convert back, you receive Rs 65.37 if the exchange rate stays static. The same investment of Rs 64.28 held in Indian treasuries without conversion yields Rs 68.37. 

The differential is too large for everything to stay stable. Any of several things could happen. The rupee might weaken, raising the value of dollar yields. The dollar might weaken, raising value of rupee yields. Or else, the yield differential could change. The dollar yield could rise or fall or the rupee yield.  

There is little chance in practice of rupee yields falling. In fact, rupee yields could rise, given higher inflation. The RBI will consider raising rates if Consumer Price Index (CPI)-based inflation runs close to six per cent. Dollar yields are guaranteed to travel up, with the Federal Reserve signalling its intention to hike rates thrice in 2018. If yield differentials narrow, rupee debt becomes less attractive for dollar investors and the rupee will weaken. 

This calculation is a crude approximation. It ignores inflation and real yields net of inflation matter. Indian inflation is currently 4.9 per cent (November CPI year-on-year change), indicating the real yield is a positive 1.5 per cent. This is already beyond the RBI’s expectation in its monetary policy statement of last week. The Fed’s inflation expectations (the US uses multiple inflation measures) are an annualised 1.7 per cent through 2018, which means dollar yield is nearly zero. So, even if we adjust for inflation, it looks as though the rupee will weaken.

Controlling currency movements is a secondary but important consideration for the RBI. The central bank's primary mandate is to keep retail inflation within a targeted band of two-six per cent, ideally with the bull's eye at four per cent. The RBI-projected inflation would run at between 4.3 and 4.7 per cent through the second half of 2017-18. Not only is CPI inflation higher, wholesale inflation calculated according to the Wholesale Price Index (WPI) rose to 3.9 per cent in November, and it's expected to go further up. 

Food and fuels are up. So are metals. Metals affect the WPI and manufacturers will try to pass on extra input costs, which will impact the CPI. Agriculture underperformed in the first half of the financial year and there are reports that rabi planting was over less acreage than last year. Hence, food prices could stay elevated. Food has 45 per cent weight in the CPI. 

If we are seeing higher nominal interest rates and a weaker currency in the future, it could be a blessing for exporters and a slight dampener for domestic industry. Exports declined in October after 14 months of growth and, given higher crude oil prices, there could be concerns about the trade balance and the current account. If exports pick up, those worries will reduce.  

Next year will probably see less flows into emerging markets from hard-currency portfolio investors. The US stock markets are at all-time highs, Japan's indices are at 25-year highs, the European Union’s major stock markets (Germany, France, Holland, Italy, Spain) are also at multi-year highs. Growth is expected to accelerate in all three First World regions. 

 That growth will automatically draw capital. It will also mean rising hard-currency interest rates in the euro and yen. Liquidity could be cut, too. The Bank of Japan is signalling a possible taper in its ongoing quantitative easing programme and the US Fed might deleverage its balance sheet. This will place some more downward pressure on the rupee. That should be good for exporters and bad for importers. A weaker rupee will give domestic industry some degree of protection from imports, too. Exporters will also gain some comfort as goods and services tax (GST) settles down, and offsets and credits come through quicker (we hope). One of the big fundamental bets for the year will, therefore, revolve around this readjustment of growth trends across the global economy.

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