According to currency experts, the rupee will strengthen by about 3-4 per cent till the end of March 2010, but it could then depreciate during the middle of the year, as central banks round the world start rolling back their stimulus measures.

Still, experts concede that the long-term outlook for the rupee looks good. This is largely because emerging market economies (EME), including India, are likely to be the primary growth engines over the next two years.

Shivom Chakravarti, economist at HDFC Bank, says, “The divergence in economic performance between developed and developing economies has played a crucial role, thus far, in driving the currencies of emerging economies higher. This is providing significant support to all EME currencies.”

Gaining ground

The rupee appreciated 5 per cent in 2009

Source: Bloomberg

Though the pace of the rupee’s rise has raised eyebrows, experts say the sharp rise is typical of the beginning of a year as asset allocation across the globe results in higher equity flows. Foreign institutional investors (FIIs) have already pumped in Rs 7,302 crore into the Indian markets in this calendar year.

Besides, according to Hemant Mishra, head, global markets - south Asia, Standard Chartered Bank, most exporters had not hedged their positions in 2009 on account of the dollar-rupee strength and they are likely do so now, which would lead to still higher inflows. Also, against a balance of payment deficit of around $20 billion last year, India is expected to have a surplus of around $25 billion in 2010, giving a further fillip to the rupee, says Mishra.

But there could be a reversal in the second quarter of the current year if leading central banks, especially the Federal Reserve, start normalising their monetary policies by reducing the amount of liquidity in the financial system. “When this takes place, we expect risky assets to lose significant support and EME assets to start correcting. The rupee is expected to depreciate at around this stage,” says Chakravarti of HDFC Bank.

The other risk experts see is from an unwinding of the dollar carry trade. An economist from another private sector bank who did not wish to be named, pointed out that EME currencies are expected to depreciate as dollar carry trades unwind in the second quarter of the year, then head higher, driven by the global re-balancing process.

Importantly, Chakravarti of HDFC Bank feels that one may have to look at the direction of the equity markets to be able to understand the future course of the rupee. “At current levels, valuations seem a tad stretched. At 22 times trailing earnings, the market is trading close to what has historically been an upper band. It is unlikely that the market will find support at these valuations and the pace of equity flows could soften going forward. If the stock market loses traction, so will the rupee,” says Chakravarti. But despite the short-term blips, the general consensus is that the rupee will end the year 2010 between 42 and 44 to the dollar.

Investors turn their back on the dollar

In a sign of the greenback’s weakness, only 62.8 per cent of currencies held by banks around the world in the second quarter, was in US dollars, the smallest portion in a decade

Source: nternational Monetary Fund; Bloomberg