Search the Internet          Tips  Sites: Finance, Investment

Rupee overvalued but needs catalyst to fall

As the firm US dollar puts downward pressure on global currencies, the relatively stable Indian rupee has become increasingly overvalued in real terms over the past few months.

But traders say the big trigger to push it sharply lower is yet to come.

At early levels of 47.05/06 per dollar on Thursday, the rupee has dropped about one per cent since the start of the fiscal year in April, and a mere 10 paise (Rs 0.10) in a week. It hit a new closing low of 47.03/04 on Wednesday.

Currency analysts estimate the rupee has firmed about four to seven per cent against its real effective exchange rate, an index measured against inflation levels of trading partners.

Some said the rupee needs to correct an overvaluation of this magnitude to remain globally competitive, while others felt up to five per cent variance with the REER could be ignored.

"Given the dollar's strength, the vigorous currency depreciation in some of South East Asian countries and the high oil prices, a corrective fall in the rupee to 47.60 seems inevitable," said V Ravikumar, head of the Bangalore-headquartered Vysya Bank's treasury.

"And it's building up to a pressure point, probably waiting for an event risk or a big (dollar) outward trigger," he said.

Despite the slow drop over the week accompanied by talk that the central bank is trying to engineer the technical correction, the rupee seems reluctant to move rapidly out of steady ranges.

Traders said a host of factors including uncertainty over the continuance of the dollar's strength and the central bank's intentions, foreign investment inflows and corporate complacency are responsible for the rupee's slow drift.

INERTIA

The inertia has also to do with the limited freedom banks and corporates have to speculate on the partially convertible rupee.

The Reserve Bank of India has maintained its let market forces determine the currency level, and steps in through state-run banks to curb large swings.

In April, the rupee hit a lifetime low of 47.10 driven by a similar need to correct an overvaluation, but recovered after central bank officials said the market was overestimating the appreciation in real terms.

"Maybe we can wait to see one more month of export numbers, and see how badly we need to devalue," said a trader with an American bank.

"But, we have to remember that once we lose export markets to others, it is very tough getting that share back."

Given declines of 3.5 per cent in the Thai baht, 6.2 per cent in the Japanese yen and 15.6 per cent in the Indonesian rupiah in 2001, the rupee's less than a per cent drop pales in comparison.

Merchandise exports rose just 5.5 per cent in April, sharply off 20 per cent recorded in the previous fiscal year.

But, unlike some Asian neighbours, India's agriculture-led economy does not rely much on its exports which just form 10 per cent of gross domestic product.

RELIABLE REAL VALUE

The extent of the rupee's overvaluation is also not clear.

Traders believe the RBI tracks the REER index with a 1993-94 base that compares the rupee against five major trading partners.

The US, Japan, France, Germany and the UK are the five countries included in the REER with the US at the highest weighting of 38.7 per cent.

That index, as per RBI numbers, has been inching up from 102.21 in April to 103.15 in May. As per market estimates, it peaked around 104.50 last week, which implies a 4.5 per cent rupee appreciation, but is now lower.

Some traders follow a closer 1999-2000 base, as per which the rupee was 6.6 per cent overvalued in May and some say the REER may be an unreliable tool to predict currency movements.

"We know the REER is mildly overvalued. But one has to exercise caution in using it to predict short-term rupee movements," said Sanjeev Sanyal, economist with Deutsche bank in Singapore.

"One has also to factor in productivity differentials between the countries, data for which is not readily available."

Tell us what you think of this report