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Informist, Monday, Jan. 13, 2025

 

By Pratiksha

 

NEW DELHI – As the rupee fell past 86-per-dollar mark on Monday, less than a month after testing its last psychologically-crucial level, it became clear that the Reserve Bank of India has shed its earlier approach of zero-tolerance for exchange rate volatility. But it will be a while before the Indian currency will be rid of the overvaluation that is a legacy of the RBI's earlier interventions.

 

A key reason due to which the RBI's earlier strategy had become unsustainable was that the rupee was becoming more and more overvalued because of the central bank standing in the way of depreciation. The rupee's real effective exchange rate against a basket of 40 currencies, based on trade weights, rose to a record 108.14 in November, suggesting that the rupee was overvalued by around 8%.

 

Since December, it seemed that the RBI had started letting go a bit, and if markets wanted further evidence, today was it. As the dollar strengthened globally after the December US employment report pointed to a resilience in the world's largest economy, the rupee fell 0.7% against the dollar to settle at 86.5750, with tacit approval from the RBI.

 

But even after the domestic unit depreciated 2.5% against the dollar since December, it is still not on its way to materially correcting its overvaluation against other currencies. It has just about managed to keep pace with other currencies which have also seen rapid depreciation, market participants said. So far this month, the rupee has depreciated 1.1% against the dollar, while other Asian currencies have fallen 0.3-1.5%.

 

"What happened in 2024 was that most Asian currencies were declining when the rupee was held very stable. So bilaterally, rupee had appreciated against its trading partners. What has happened off late is that the rupee is only coming into line with the trend the regional currencies are showing but is not depreciating substantially more than others, it's more or less in line. It has a lot of catching up to do," said Dhiraj Nim, FX strategist at ANZ Banking Group.

 

In 2024, the rupee fell 2.9% against the dollar, while other Asian currencies fell 3.0%-11.9%, barring the Thai baht and Malaysian ringgit, which gained against the US unit. But the only way for the rupee to strip off the overvaluation is either by exceeding the pace of depreciation in other currencies, or by not appreciating when the other currencies do. Both situations seem highly unlikely for now.

 

Market participants are of the view that with US President-elect Donald Trump's return to the White House next week, the future paints a bleak picture for emerging market units and the rupee may not find enough space to reverse its overvaluation due to the same.

 

The dollar index, which measures the strength of the dollar against a basket of six major currencies, has risen over 5% since December, and is only expected to strengthen further on the back of Trump's proposed protectionist policies. 

 

Moreover, the outlook for foreign fund inflows into Indian market remains subdued in the face of looming uncertainty over Trump's administration, clouding any opportunity for the Indian currency to appreciate. In fact, so far this month, foreign portfolio investors have pulled out almost $3.1 billion from domestic markets on a net basis.

 

"If other Asian currencies are falling in line with the rupee, I don't think the rupee overvaluation will correct too much," said Madhvi Arora, chief economist at Emkay Global Financial Services. "But I feel the worst may be over for REER, since they (the RBI) are letting the rupee move a bit."

 

A section of the market, however, is of the view that the RBI's loosening grip on the currency may, in fact, lead to some correction in its overvaluation against its peers. "When we are saying the rupee has depreciated less than other currencies, there have been a lot of sales of dollars that has taken place. To that extent, the rupee has been overvalued," said Madan Sabnavis, chief economist at Bank of Baroda. "But today we can see that the RBI may not be intervening to that extent. So, therefore, it is the market forces that are determining the currency rate, that itself will move to some sort of a fair value, which means some overvaluation may reduce."

 

 

As long as the Indian unit remains sharply overvalued, it will be a candidate for speculation, which will only exacerbate the weakness in the rupee. On the other hand, it benefits FPIs, who can withdraw their capital at overvalued rupee valuations and re-enter Indian markets at a cheaper currency valuation.

 

Of course, the rupee need not correct 8% against its trade partners to reach an acceptable valuation. According to experts, around 4-5% overvaluation is a palatable level for the rupee.

 

However, if the central bank sustainably lets go of its hold on the Indian currency, market participants are of the view that the overvaluation in the domestic currency may reverse in the medium term if not now. After the rapid decline in the currency since last month, they expect the local currency to test 88.00-88.50 per dollar by March. The fact that the RBI allowed the rupee to suffer its worst fall in nearly two years today was a heartening start of a journey towards achieving more realistic currency valuation, market participants said.  End

 

US$1 = INR 86.58

 

Edited by Akul Nishant Akhoury

 

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