During Raghuram Rajan’s tenure, India has become an “island of stability in turbulent seas”, but his exit—just like when he started his term—would likely be marked by currency market volatility.
His decision is certainly unexpected as far as the currency markets are concerned. The rupee has shed just 0.3% in the one month since Bharatiya Janata Party member of Parliament Subramanian Swamy unleashed a serious of vitriolic attacks against the central bank governor. When the rupee is likely to come under pressure, can debt and equity markets be left far behind?
To be sure, any sharp fall in the rupee on Monday could well be termed knee-jerk. Market experts such as A.V. Rajwade, an independent treasury and forex consultant, expect a “significant intervention on part of RBI” to ensure the currency doesn’t drop too much. That said, Rajan’s exit could be the proverbial straw that broke the camel’s back. Over the past couple of months, a number of factors have emerged that have led economists to make forecasts of the rupee weakening to a low of 70 per dollar by the end of the year.
The uncertainty over the UK leaving the European Union, termed Brexit, could lead to economic chaos and financial instability in that region, forcing a safe-haven flight to dollar assets. The vote that happens on Wednesday will make things clearer.
While the threat of a US Fed hike in interest rates has abated for now, the dollar outflow on account of FCNR(B) deposits of about $20 billion could add to volatility. Indeed, RBI has been preparing for this by buying dollar forwards from banks. However, the banking system is likely to face trouble since exporters (from whom they buy dollars) typically roll over a significant portion of their contracts. This will lead to bouts of volatility.
These mini storms couldn’t be brewing at a worse time for the Indian markets. As the March quarter balance of payments numbers show, the current account deficit has not improved as much as expected and is likely to get worse this fiscal year because of a sustained weakness in remittances and services exports. Oil prices are climbing again, and this will necessarily lead to increased dollar demand, putting pressure on the rupee.
Secondly, while capital inflows have generally been enough to fund the current account deficit, they fell to a seven-year low in the March quarter. They are expected to come under pressure in the coming quarters as well. In the current quarter, with only about 10 trading days left, net portfolio inflows are barely above $1 billion. Net capital inflows, especially in the face of global uncertainty, will ultimately decide whether the rupee can pull back from this 70-to-a-dollar type of forecasts.
Foreign portfolio investors have been exiting bonds in the past month or so, and the rupee’s fall could well spark an exodus from this category. In the face of such pressures, the government will need to make up its mind fast and appoint a new governor of a similar intellectual calibre—or brand value, if you will—as Rajan.
“Markets will remain volatile as long as it takes for a new governor to establish credibility,” said Saurabh Mukherjea, chief executive of institutional equities at Ambit Capital Ltd.