Indian rupee rises into uncharted territory

India's GDP surged 10.4% y/y in the period October-December 2003, with agriculture, forestry, and fishing leading the way with a 16.9% y/y expansion. As we have pointed out earlier, the economic revival is not just about agriculture. The trade, hotels, transport, and communication segment continued its strong performance from the previous quarter, rising 13.1% y/y. We have been arguing that the manufacturing sector is likely to gather momentum going forward. The latest GDP data support that, as growth in that sector has steadily risen over the financial year 2003/2004. That said, GDP growth in excess of 10% is not sustainable into 2004/2005. Agriculture is unlikely to grow as robustly from a higher base. Therefore, GDP growth rate is likely to recede to about 7% in the fiscal year ahead. Even that forecast is contingent upon a good monsoon.

Meanwhile, the INR has appreciated by an unprecedented 3.5% since March 18. The Reserve Bank tends to monitor the real effective exchange rate of the INR over the medium-term. The fair value is widely believed to be the average REER for the FY 1993/1994. Given that benchmark, the INR had been trading in a tight range over the last one and half years. After this latest move, the currency is overvalued by about 5% using the 1993/94 benchmark. In the past, such a level would signal the need for currency depreciation. However, the central bank has been conspicuously absent this time around. We are in uncharted FX territory. We highlighted this possibility in our daily of 20 February 2004 titled "India: Dealing with imported inflation."

There are several possible explanations why the central bank has been absent from the market. One, the Reserve Bank has run out of securities to sterilise FX intervention, and so it is not buying USD anymore to avoid an excessive build-up of INR liquidity. That trend should reverse in the new financial year when the central bank starts selling the newly instituted market stabilisation bonds. Two, RBI has let the currency gain on the back of a temporary excess supply of dollars (from recent IPO inflows). That view is supported by the Chief Economic Advisor's comments that the recent rise of the currency is temporary. Three, the exchange rate has been allowed to appreciate to control inflation. We highlighted that possibility earlier, and recent comments by the Finance Minister support that view. Four, the RBI has re-based the REER in light of fundamental changes in the balance of payments. For example, increased IT-related inflows in the second half of the 1990s imply a higher trade-weighted INR. If the RBI has indeed re-based the INR, then it is hard to tell where the currency will finally settle. The year 2001 may be a good contender for the new base year. The current account surplus in FY 2001/2002 was about USD 782mn. With reference to that new benchmark, a level of 44 for USD/INR would be the new approximate fair value, given the currency levels of India's trading partners. Given our current FX forecasts it would also imply an USD/INR rate of 42 by Q1 2005.

In sum, we are very much in uncharted FX territory. Each of the above arguments has some merit. It is only once the currency stabilises that firm conclusions can be drawn. Though a temporary spike on account of a short squeeze cannot be ruled out, the nature of the move suggests that it is not temporary. We are inclined to believe that high imported inflation has triggered this move. In the past high inflation has led to election reversals. Low interest rates are a key peg in the BJP's "India Shining" theme, ruling out rate hikes as a tool to control the price rise. That leaves a stronger INR as the only credible politically feasible policy option.