DSP Merrill Lynch's latest forex report (Cause & FX - INR: Stronger into 2005), forecasts that that internal dynamics and global developments will prompt the the Reserve Bank to gradually 'acquiesce' to the strength of the rupee. An analysis of the RBI's exchange rate management had led to expectations of a shift in policy focus towards addressing excess liquidity and inflation (Cause & FX: The Rationale for the Rupee, October 19 2004).
The report states, " We had expected the RBI to tolerate some INR overvaluation in real exchange rate terms, given our views of general dollar weakness against the JPY and EUR and an appreciation of the RMB. Local factors such as inflation and strong inflows into India would also influence the central bank's view."
What has happened since then?
1. Some tolerance to FX strength is already visible. The RBI has allowed the rupee to appreciate in recent months, intervening only to reduce volatility and slow the pace of appreciation. Data available on the RBI's FX purchases and sales shows that RBI intervention was marginal in September and October.
Intervention, in the form of dollar purchases would have increased in the last two months of 2004 given the sharp rise in reserves. The RBI governor also said that FX inflows were stronger than anticipated and could create challenges in liquidity management.
2. The liquidity management agenda has shifted. Concerns over inflation have pushed liquidity management high up on the RBI's agenda. From a situation of excess liquidity conditions in the money market, the RBI has managed to move to a situation of 'appropriate' liquidity.
The RBI hiked the 'cash reserve ratio' (cash balances banks need to hold with the RBI) by 50bp, effectively withdrawing some Rs90bn of liquidity. The market stabilisation scheme was made operational in FY2005 - the RBI has mopped up approximately Rs550bn of liquidity and plans to absorb another Rs130bn in Q4 FY2005. The RBI's measures have reduced excess liquidity in the system from a high of Rs900bn in April 2004 to around zero in December 2004.
Aiding the RBI's efforts on liquidity management has been the surplus with the central government. Lead-lags in government finances coupled with an improvement in the fiscal situation has led to a situation of excess cash to the tune of INR200bn with the government.
3. Inflation concerns persist. Inflation, as measured by the 'wholesale price index', is at 6.5 per cent, down from 8.7 per cent recorded in August. The RBI expects inflation to be around 6.5 per cent in March 2005. At the same time they acknowledge that inflationary expectations have increased from the 4-5 per cent band.
Despite the recent fall in the inflation index, inflationary pressures remain visible in the economy. Sustained high raw material and fuel prices (largely imported) are now filtering into end products. Manufacturers have started hiking prices of automobiles and engineering equipment. We expect the RBI to keep a close tab on inflation and be wary of signs of accelerating inflation pressures.
The report also states, "Our Asian economists expect inflation in the region to remain high in 2005. This might also prompt the RBI to tolerate some strength in broad REER terms until there are clear signs that inflationary pressures are abating."
The RBI has already hiked the reverse repo rate by 25bp in November to 4.75 per cent and made liquidity conditions more balanced.
4. Some respite from flows. The sharp rise in the trade deficit and a pullback in capital flows took some burden away from the exchange rate in 2004. However, given the recent sharp fall in crude prices and expected improvement in flows, the RBI would again be faced with the dilemma of managing the exchange rate and liquidity. We believe that liquidity management considerations will prevail and the RBI will let flows determine the INR move, at least until current supporting factors experience a reversal.
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DSP Merrill Lynch forex
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