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Over the past three weeks, the focus in India of the foreign exchange market has been on the real effective exchange rate -- REER -- of the rupee and the recent endorsement by the Reserve Bank of India that the rupee is over-valued. Most calculations show that the REER is at about Rs 40 per US dollar as compared to the nominal or market rate which is at 36.45.

Even though no fundamental indicator has changed drastically (if anything, official inflation rate declined) in the last three weeks, there has been a slight shift in sentiment amongst market players. It is widely agreed that the recent slide of the rupee has been due to the change in the demand-supply situation. Importers and borrowers in foreign currency have begun to hedge their payables. The high cost of cover (above 7% per annum) is, however, proving to be a deterrent. The perception has been that in this period, the main supply has been through RBI intervention and companies are postponing their receivables until the crisis abates. Data released earlier this week by the RBI, however, suggests that corporate spot supply has been maintained which has been countered by a pick up in demand for forward dollars.

The much awaited oil price hike has finally been effected, but we do not expect this to have a significant direct impact on the foreign exchange market. We believe that the benefit of an improved balance sheet for the oil companies would in fact enable them to have international offerings (equity and debt) which will add to capital inflows. This, of course, hinges on the government raising the external commercial borrowing ceiling for Indian Oil Corporation, which we expect will happen.

There have been several statements from the government that the market will be free to determine the value of the rupee but the RBI will intervene to prevent volatility. We believe that most market players will look to the RBI to provide direction. Thus, the key question remains: "At what level does the government want the rupee to be and what is the manner in which this is going to be achieved?" The factors which will be under consideration are:
a. How much will Indian exports suffer if the rupee remains overvalued in REER terms?
b. What are the negative implications of a sharp depreciation (of say 10%) in the next few months?
c. What will be the effect of sentiment of the southeast Asian currency crisis?

Let us examine each of these factors:

a. Two arguments that support the depreciation of rupee are higher domestic inflation (compared to our trading partners) and a stronger currency (compared to rest of the region) which adversely affect export competitiveness. A look at Indian exports shows that they grew by over 15 per cent per annum between April 1993 and April 1997, as compared to 6 per cent per annum in the previous decade.

This increase in growth has been due to progressive relaxations in the export-import policy and incentives to exporters in the form of concessional financing, and not just a depreciating rupee. Over the last four years, many Indian exporters have enjoyed dollar rates of interest for their financing and some of them have reduced their rupee borrowing costs (already at concessional rates) by receiving forward premium. We believe that Indian exports can remain competitive by this and through improved productivity and infrastructure support.

b. One impact of a 10 per cent weaker rupee would be on the $7 billion oil import bill, which in combination with the recent petrol hike and the high money supply growth through 1997, would lead to much higher inflation in 1998. A weaker rupee would also act as a deterrent for imports. The government's hope for corporate activity and capital expansion this year is likely to receive a setback. Further, it is well known that the corporate sector is exposed to currency risk -- importers have not covered themselves and most companies have resorted to foreign currency borrowings which are also unhedged. Thus, there will be an adverse impact on corporate earnings in 1998.

c. Undoubtedly, the international investor has clubbed India with other Asian Tigers and believes that the rupee too needs to slip by about 10 per cent immediately. This is reflected in the overseas non-deliverable forward market which is quoting a six-month rate at Rs 40 per dollar. This compares with the onshore six-month forward rate of Rs 37.70 per dollar. The local stock index is already over 4000 (BSE on Monday) and we estimate that even if it were it fall to 3500, it would result in net sales by the foreign investor of less than US $400 million, an amount which can easily be countered by central bank intervention.

In conclusion and all factors considered, we believe the RBI would not like a sudden fall in the rupee but would like to see a gradual depreciation. If the RBI continues to defend the rupee at 36.50-70 (which we believe it can and will) over the next few weeks, the apprehensions of importers would subside and the demand-supply situation will revert in favour of the rupee. However, volatility in the immediate future cannot be ruled out as both importers and exporters try to find the right level for the rupee. Looking ahead, we expect that a depreciation of 4 to 5 per cent over the next year would find favour with the government and the rupee would move to Rs 37.50 per dollar by June 1998.

Amit Gupta is senior economist and Naveen Choppara is economist at the Hong Kong & Shanghai Banking Corporation in Bombay. The opinions expressed in this article are their own and do not represent the bank's point of view.