Subhasish Roy

ALTHOUGH the Indian rupee has been appreciating steadily since August 2004 against the dollar, the trend is unlikely to continue. Indeed, it has begun to depreciate in the last few days. And considering the strength of the US currency in the international market, it can be said that the rupee is clearly overvalued.

Fundamentals of the Indian economy are, however, comparatively strong — reflected in the different macro-economic parameters, including improved business and political confidence indexes.

However, in the external sector, the trade and current account deficits are very high. According to latest figures, the trade deficit climbed sharply to $11.5 billion in April-June 2005, up from $ 6 billion in April-June 2004. The higher trade deficit is on account of higher growth of non-oil imports in recent months compared to export growth.

As the economy grows, non-oil imports will grow even more rapidly. With the volatility of oil prices, it is more likely that the oil imports bill will also go up. All this will adversely effect the trade balance. As for current account, India's went from a surplus ($10.6 billion) in 2003-04, to a deficit ($6.4 billion) in 2004-05.

Taking into account the expected 7 per cent gross domestic product (GDP) growth in 2005-06, the current account deficit could widen to - 1.4 per cent of GDP in 2005-06. These factors will increase the demand for the US dollar and hence weaken the rupee.

In the equity market, the flow of foreign capital until now counter-balanced the deteriorating current account, and in combination with the foreign capital raised by domestic companies, kept the rupee on a rising track. While domestic firms will continue to raise foreign capital at a healthy pace and the uptrend in Foreign Institutional Investments will continue, it is unlikely that the foreign fund flows will adequately compensate the future deterioration in the current and trade account balances. This will put the rupee under pressure.

The latest indices of REER (real effective exchange rate), which is around 109.6, also indicates that further upward movement of REER will be limited as the Reserve Bank of India (RBI) may keep the volatility of REER movements in the band of (+/-) 5 per cent of its base index 100.

A strong rupee is beneficial to the importer, but it will make the country's exports uncompetitive and impede export growth, thus contributing to a higher trade deficit. In the current scenario, higher growth of exports is crucial to improving the trade deficit. Thus, the RBI will not allow REER indices to exceed 105.

It is pertinent to note that the RBI allowed REER to touch the 110 level to contain inflationary forces; an overvalued rupee in times of higher import prices keep inflation at manageable levels. But given the comparatively lower inflation levels, it can be said that the RBI will now take action to bring back the value of REER at least to the level of 105.

The revaluation of the yuan will not have a significant impact on the rupee. The 2 per cent revaluation of the yuan will not make India's exports more competitive, as the price elasticity of demand for Indian goods is not high enough. Also, following the yuan revaluation, it is likely that some other Asian countries will follow the same route.

Further, the European Union faces two fundamental and inter-connected problems. First, the problem of bridging the gap between the political elite and the people and, second, the economic model on which to build the strategy for the new millennium.

Under the circumstances, the strategy of "enhanced cooperation" may be the only solution. However, considering the current socio-economic situation of the region, it can be said that the prospect of a "United States of Europe" is very dim. Thus disturbance in the Euro region will continue in the medium term. In the future, there could be some adverse effects on the strength of the euro that could generate more demand for the dollar in the international market. A higher demand for the dollar could weaken the rupee.

Further, the higher equity prices in the global equity market could increase demand for the dollar if the US market attracts money from overseas. All this may add some strength to the dollar in the medium term and weaken the rupee.

Though the above factors indicate that the rupee will depreciate by some percentage points in the medium-term (the next six months), there may not be any volatility in the exchange rate of USD/rupee. This is because the RBI's broad objective is to ensure that the external value of the rupee is realistic, by meaningfully minimising volatility of the forex market and maintaining flexibility of exchange rates to safeguard external trade.

(The author is Assistant General Manager, Corporate Strategy and Planning Department, IDBI Ltd. The views are of the author and may not reflect those of the institution he belongs to.)

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