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Home / Markets / Mark To Market /  The rupee has been on a winning streak. It's about to end now

On Friday, the Indian rupee hit a three-week low, dropping half a per cent in a single trading session. While this may not stand out given the larger weak market sentiment globally, it should. That is because the rupee was, so far in November, on an appreciating trend, despite the dollar index (DXY) rising nearly 3%, the highest in five years.

Does Friday’s loss indicate the beginning of the Indian exchange rate’s downward trend? One metric that points to the possibility is real effective exchange rate (Reer). Analysts at independent research firm QuantEco Ltd have pointed out that the rupee could be overvalued as much as 10% in Reer terms.

Starching value
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Starching value

Simply put, the rupee should be weaker than what it is in the context of macroeconomic indicators. What makes the rupee’s strength look out of place is the recent weakness in most Asian peers.The rupee has gained against 38 currencies out of 40 in Reer. “We estimate this relative outperformance of INR to increase its overvaluation on Reer basis to 9.4–9.9% in November 2021, the strongest level in nearly 4 years," the QuantEco report said.

According to Reserve Bank of India data, overvaluation of the rupee in terms of Reer of a 40-currency basket stood at 5.45% in October.

To be sure, the Reer has indicated an overvaluation since 2019. This has coincided with the unprecedented dollar inflows into domestic markets, especially equities. While the RBI has absorbed a lot of these flows, the amount has been significant. Foreign investors have poured in $12 billion into domestic equities and bonds so far in 2021, and that has meant that the rupee has gained 2.5%. This winning streak is about to end now.

“Seen from a historical context, the current negative correlation between DXY and USDINR is getting ripe for a reversal. This holds from a Reer perspective as well, where historical reversals in overvaluation have got triggered in the 8-12% range," the QuantEco report said.

The resurgence in pandemic fears may be a ruse to sell the rupee but the real underlying reason is that investors may be finally noticing the exchange rate’s overvaluation.

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