Markets, rupee withstand downgrades

By Oommen A. Ninan

The rupee and the Government of India securities (Gilt) markets have withstood the downgrade of India by international rating agencies, Standard and Poor's (S&P) and Moody's Investors Service (Moody's).

The rupee closed the week at 47.12 a dollar having recovered from a low of 47.18 following a knee-jerk reaction to the downgrade by the rating agencies. The Indian currency fell initially as nervous importers and banks sought dollars fearing a sharp decline in value of the rupee.

However, timely action by the State-run banks, which sold dollars at 47.17, paved the way for its recovery. ``Corporate India did not panic and the usual rush for dollars was missing,'' said Mr. N. Subramanian, forex consultant with e-Mecklai, adding, ``The speculators unwound their long dollar position while exporters also sold dollars having held back initially in the hope that the domestic currency would decline sharply."

In the government securities (gilts) market, prices fell immediately after the announcement of the downgrade. However, prices firmed up following reassuring statements by the Reserve Bank of India Governor.

In fact, gilt prices continued to rise for the third day (closing Friday) in a row after the S&P's and Moody's downgrading, with prices in the long-term rallying by 30-40 paise and those in the medium and short term moving up by 10-15 paise from the previous close.

S&P's and Moody's have lowered India's sovereign rating outlook by a grade. Bv`1asw2The S&P officials said that unchecked budget deficits and rising domestic indebtedness and worsening of India's fiscal situation were the reasons behind their decision.

The rating agency expects the combined Central and State budget deficit to exceed 10 per cent of India's gross domestic product (GDP) and total government debt to touch 70 per cent of the GDP.

They also cautioned that public finances might worsen further in the years to come, which might trigger downgrades of its foreign and local currency sovereign credit rating. However, it affirmed a BB long-term and B short-term foreign currency rating.

Close on its heels came the downgrade by Moody's. It lowered the outlook for India's foreign currency to stable from positive and domestic currency debt to negative from positive.

``It was something which was not unexpected and I think it should not have a very big impact because of the fortunes of the rupee, in the immediate term, more driven by demand and supply conditions in the market,'' said Mr. Srinivas Varadarajan, Co- Head, Foreign Exchange, JP Morgan.

The Union Finance Minister, Mr. Yashwant Sinha, said the reasons given by both the rating agencies for the downgrade were based on hasty conclusions. He said the stock market indices and the Indian rupee were hardly impacted by the downgrade and that it was a fitting reply. ``But Mr. Sinha's reaction seems poor consolation in the face of the stark facts emphasised by the rating agency,'' felt the e-Mecklai consultant. The government needs to take drastic action to correct the situation to avoid further downgrades in future. At the moment, the government has its hands full and does not want a new one on the exchange rate front.

``Market participants have been fully aware of the rupee's over- valuation by almost 3 per cent in terms of real effective exchange rate (REER) but the authorities have made no attempt to push the local currency weaker against the dollar, as they have done in the past,'' said Mr. Subramanian. It has managed to keep it under a tighter range - between Rs. 47.10 and Rs. 47.20 a dollar - for over two months now by absorbing excess dollar supplies and also by relieving the pressure off the rupee aided by a drastic fall in dollar demand.

The slowdown in the economy has led to poor demand for dollars especially from corporates towards expansion projects and also due to weaker commodity prices including crude oil. Another reason for the poor demand might be the rupee's steep depreciation itself, as over the last five years the rupee has seen erosion of 33 per cent of its value against the dollar. It has scared the wits out of the most enterprising Indian corporates ``which have either swapped or prepaid their external borrowings in the last few years thus cutting down their exposure on the dollar.''

On the supply side, huge capital inflows seen during the current calendar year with over $2.6 billion of net investments by foreign institutional investors in Indian bonds and equities have supported the rupee. The stable currency has also dissuaded exporters from holding back dollars in Exchange Earners' Foreign Currency deposits as it does not earn them interest income on such accounts.

There is one more dimension to the argument. Given the recent dollar weakness the extent of overvaluation in real effective exchange rate is also coming off. ``Thus'', said Mr. Varadarajan, ``both from the valuation and demand supply perspective the rupee is unlikely to witness any large movement and will be confined to moving in a narrow range.''

Rating agencies have highlighted certain structural weaknesses which should be taken as good advice and in a constructive manner. While the outlook is currently negative it would possibly be reviewed if certain initiatives such as adoption and enactment of the Fiscal Responsibility Bill and further measures on privatisation come through.

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