FIIs largely responsible for sharp volatility in Rupee-Dollar rates – Report

Fund flows from Foreign Institutional Investors reacting to global and local factors is largely behind the sharp fluctuation in the value of the Rupee over the last few days, Crisil Research has said.

While predicting that the Indian currency will recover much of the ground lost over the past one month or so, the agency pointed out that tighter global liquidity caused by cut backs in central bank funding will continue to weigh on emerging markets currencies.

Crisil Research, associated with ratings firm CRISIL, pointed out that a withdrawal of $4.2 billion from the Indian stock markets by foreign investors (FIIs) in the first 21 days of June has hit Rupee hard. The fall, which began in early May, was initially triggered by a sharp increase in gold imports, Crisil Research said.

In May, FIIs had pumped $5 billion into the Indian markets, but this was not enough to stem the fall.

The research firm expects the Rupee to rise to 56 per dollar by March 2014, but said that would depend on several factors.

“The current capital flight from India is a short term phenomenon and is largely in response to the uncertainty surrounding the impact of the Federal Reserve’s pullback of QE. The government is pledging a slew of domestic policy reforms to shore up domestic and foreign investor sentiments. This will act as a pull factor for foreign capital inflows.

“We expect current account deficit as a per cent of GDP to be lower in 2013-14 vis-à-vis last year. Despite the expected appreciation, the rupee is likely to remain volatile and end the fiscal year on a weaker note (Rs 56/USD) than earlier expected. This is because the quantum of capital inflows will be lower as the Federal Reserve winds up its bond buying program later this year,” it said.

Crisil pointed out that the currencies of economies with higher foreign funding requirements lose their value compared to the dollar.

Brazil, Indonesia, Turkey, Korea, Russia, Philippines and South Africa saw their currencies weaken by 5-17 per cent. Among these, the South African Rand, Brazilian Real and Russian Rouble depreciated the most, as these economies have a high current account deficit and rely heavily on foreign funding.

“The increasing vulnerability of India’s external account impairs the rupee’s ability to counter even smaller shocks,” Crisil said.

The rupee saw a steady phase of appreciation from 2003-04 to 2007-08. Since then, however, the currency has been on a depreciation trend and seen massive volatility.

“Instances of weakness in the currency are very highly associated with periods of slowing growth,” the research firm said.

“Every phase of sharp depreciation since 2008 has been followed by gradual appreciation, but the rupee fails to come back to its previous level. In fact, the rupee is yet to recover from the fall it experienced in the aftermath of the Lehman crisis,” it said.

The agency warned that India’s high current account deficit — which is usually met by investment inflows — is putting the country and the currency at a high risk.

“As global liquidity tightens, large quantum of capital inflows (around US$ 90 billion) needed to finance the CAD puts the external sector at risk and exposes the rupee to larger volatility.

“Not only has India’s GDP growth come down sharply, its gap with the advanced countries too has narrowed. India has seen a sharp reduction in growth differential with the United States (380 basis points in 2013/2014 against 960 basis points in 2009 when FII inflows were the highest),” it said.

Return of foreign capital in the short term will critically depend on adopting the right policy mix to attract higher investment inflows and improve growth prospects of the economy, it said.

“Over the medium term, the government must focus on adopting policies that tame the CAD and those that ensure higher inflows of durable foreign capital investment to finance it. Speedy return to high growth on a sustained basis will be a critical pull factor. If this happens rupee can regain its long term appreciation bias,” Crisil pointed out.