What Should be RBI's Stance on the Rising Rupee

Fri, 28 Apr Pre-Open

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The Indian rupee ended at 64.15 to the Dollar, its strongest showing in the last twenty months. Since January 2017, the rupee has appreciated by more than 5 percent. This has mainly been on account of strong foreign inflows.

Foreign portfolio investors (FPI) have invested more than USD 14 billion since January 2017. This is on the back of positive developments on the domestic front. Expected roll out of the Goods and Services tax and other reforms, 7-8 percent estimated GDP growth, and other factors have led to rupee outperforming most emerging market currencies since the turn of the year.

How does it impact Indian companies going forward? The earnings of companies dependent on exports are likely to be affected adversely. My colleague Rahul Shah, in the 5 Min Premium has discussed this impact on the IT sector (subscription required). Apart from the IT sector, Pharma companies will also be affected due their high exposure to the US and European markets. Both these sectors have been badly hit in the past year due to geopolitical factors.

Margins of steel companies are also likely to be under pressure. Until recently, these companies had done well due to growing export demand. India turned a net exporter of steel in 2016-17 after a gap of three years. But recent drop in prices of Chinese hot-rolled coil prices along with a strong rupee is a concern.

How does the RBI tackle this? For one, it can buy the excess dollars from the market. This will keep the rupee stable. India's forex reserves currently stands at USD 369 billion. These reserves though come at a cost. RBI earns a low rate of return on these reserves (around 1%) by investing in US government securities. Alternatively, they are losing out on around 6% by forgoing rupees for dollars. This implies a net loss of 5% in the RBI's Profit and Loss statement.

The other option it has it to allow the rupee dollar rate to be determined by the market forces of demand and supply. RBI's real effective exchange rate index stands at 117, implying that the rupee is overvalued by 17%. Once there is a likely slowdown in the FPI inflows, rupee will revert to its normal levels. Hence, it makes sense for the RBI to not intervene and let the rupee gradually shift to its fair valuation.

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