Reviewing the Indian rupee's performance (page 2 of 2)

in particular was also needed. In turn, the INR may see further volatility near term and at least has the potential to appreciate towards the 43.00 levels given these factors. The extent of any INR move will of course be contingent to a large degree on the adjustment in other Asian currencies. An important difference between the INR and many other regional currencies (for example KRW, TWD, SGD) is that it does not enjoy a strong trade surplus. On the contrary, the Indian trade balance is in deficit and this deficit is reaching record highs. We thus expect any gains in the INR to be short-lived.

Loss of INR competitiveness is a Longer-Term Concern

The RBI uses the Real Effective Exchange Rate (REER) to assess the INR's competitiveness. Based on the Standard Chartered INR REER index, which essentially replicates the RBI's 5- country REER (base year 1993-94), the INR's real value has rarely been outside a 3.5-4.0% band. However, it is currently roughly 7% overvalued in comparison with its equilibrium value of 100 (1993-94 parity). An overtly overvalued currency over a sustained period of time will impact India's trade competitiveness. This is because an overvalued currency makes imports cheaper and exports more expensive and thus exacerbates trade imbalances and hurts growth. Thus, the central bank in such a situation can either intervene in the foreign exchange markets and correct the imbalances or alternatively allow market forces to do so.

RBI focus is on Inflation Management

This year the REER has stayed close to the steep end of its observed range. The RBI's tolerance for an overvalued rupee has partially to do with its desire to maintain a balance between inflation and growth with the balance of risks having shifted to equal emphasis on growth and inflation in our assessment. An overvalued currency in an environment of high imported prices, can moderate inflationary pressures and this we see as a key reason why the INR remains overvalued near term. Once the inflation rate retreads back to more tolerable levels, the overvaluation concerns would once again get back into focus.

Record Trade Deficits

In 2004/05 India recorded its largest ever-annual trade deficit of -USD26.5bln due to high oil and goods imports. Even the trade gap excluding oil imports has been negative since mid-2004. This high deficit was despite a healthy 25% growth in exports. More recently the monthly trade deficit in April 2005 was a record -USD3.85bln, the largest monthly deficit in India's history. The current account has also deteriorated switching from a record high surplus of USD8.1bln in 2003/04 into deficit. In the first 9 months of 2004/05 the deficit stood at -USD7.4bln. We expect the current account to remain in deficit (-1.0% of GDP) in 2004/05 and (-0.8%) in 2005/06.

US, China Slowdown May Cause Further Deterioration

Given the expected slowdown in global growth, especially in the US and China (two of India's largest trade partners), India's export growth is likely to decelerate to 15% in 2005/06 from 25% in 2004/05. The recent comments by the Finance Minister hint at growing concerns regarding the rising trade deficit - "we need to see that the trade deficit doesn't become an albatross around India's neck".

Capital Inflows Expected to Remain Strong

Recent overseas equity issues and the pipeline of issues for some Indian companies, together with awaited external commercial borrowing proceeds should keep capital inflows steady through 2005. Recent affirmative policy measures by the government such as relaxation of foreign investment limits in construction and telecommunications sectors, together with prospects of further relaxation in controls in other sectors such as mining, signal improving prospects for FDI. To a considerable extent this will limit sharp INR depreciation. Given concerns on inflation, we now expect the RBI to hike the reverse repo rate once again at the quarterly meeting in July.

As a result, we revise our INR forecasts to 43.3 by end-June 2005 with a 30% probability that it could touch 42.9. However, we then see a gradual depreciation of the INR and retain our March 2006 INR forecast of 44.0/USD. The downside risks are however, limited by the expected strong capital inflows.

FX Strategy
Callum Henderson
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David Mann
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Eric Chong
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Marios Maratheftis
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Economics
Shuchita Mehta
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