Rupee defence succeeds -- for now

A Kashmiri vendor exchanging damaged rupee notes waits for customers at a market in Srinagar November 20, 2006.

MUMBAI (Reuters) - The Reserve Bank of India's victory in reversing a sharp decline in the rupee may be short-lived and the currency will remain vulnerable unless the problems of a hefty fiscal and current account deficit are addressed.

The rupee plunged to a record low of 54.30 to the dollar in mid-December, prompting the RBI to unleash an uncharacteristically aggressive slew of measures to support it.

Those efforts, including heavy dollar selling as well as administrative measures, restored confidence and reversed the decline, with the rupee strengthening past 50 in January and the central bank indulging in a round of crowing over its success.

However, these measures are quick-fixes and rupee is still susceptible, meaning the tide of funds that has flooded into India this year could just as quickly reverse.

"The fundamental problem remains the structural BoP (balance of payments) deficit and weak fiscal position," said Andy Ji, Asian currency strategist for Commonwealth Bank of Australia in Singapore.

"Both require substantial and sustained funding sources. Until then, the INR will remain the laggard in Asia, fluctuating to the volatile risk sentiment," he said.

A worsening of Europe's prolonged sovereign debt crisis could trigger a reversal of funds from emerging markets, and India with its economic reforms logjam, high inflation and twin deficits could be among the worst hit.

"Since the rupee's turnaround has been helped by the opening up of the capital account, the authorities would do well to worry that what comes in can go out readily," Deutsche Bank economist Taimur Baig wrote in a note last week.

Foreign investors have poured over $7 billion into Indian debt and equities, causing the rupee to gain more than 7.5 percent so far, after diving about 16 percent in 2011.

In contrast, other major Asian currencies like Thailand's Baht had fallen around 5 percent while the Japanese Yen and Chinese Yuan had gained more than 4 percent in the same period.

In coming weeks, the rupee is likely to face volatile trading as investors await a resolution of Europe's debt crisis.

"If you have an implosion in Europe, then you could start to see the currency test even the previous low because then it is a very serious downside scenario," said Leif Eskesen, Chief Economist for India & ASEAN for HSBC in Singapore.

TAKING ACTION

The rupee appears to be stabilising as its real effective exchange rate (REER) is moving towards neutral, RBI Deputy Governor Subir Gokarn said, adding that the central bank's measures have lowered the rupee's volatility.

The REER is the rupee's value against a basket of currencies of India's largest trading partners, adjusted for inflation.

In nearly 10 months to January 13, the 6, 30 and 36-currency trade-weighted REER depreciated by about 9 per cent each, reflecting nominal depreciation of the rupee against the dollar by about 13.2 percent, the RBI said last month.

Between late July and mid-December the rupee fell more than 19 percent, with sharp drops prompting fears of a speculative attack against the partially convertible currency and forcing the RBI to act.

The RBI, which is officially agnostic about the value of the currency and steps in only to curb volatility, sold $4.5 billion in the spot and forward markets in November, its third straight month of dollar-selling. Its spot market dollar sales were the highest since March 2009.

In other steps, it removed the interest rate ceiling on deposits by non-resident Indians, triggering a flood of yield-hungry inflows from the country's large diaspora.

New Delhi also raised the limit on foreign institutional investment in government and corporate bonds by $5 billion each to $15 billion and $45 billlion, further boosting inflows.

The RBI on December 15 also clamped down on banks' trading limits to cut speculators out, a move that traders say has cut liquidity by about 35 percent. It has since relaxed the limits slightly for some banks on a case-by-case basis.

FISCAL WOES

While the measures have had their desired effect, the rupee remains exposed to weak economic fundamentals and fickle global flows.

India's fiscal deficit during April to December was 92.3 percent of the target of 4.6 percent of GDP for the fiscal year that ends next month, while imports again outpaced exports in January, leaving a trade deficit of $14.7 billion.

Growth is slowing, reforms have been stalled, and inflation, while falling, remains a worry. New Delhi's penchant for populist spending, including a potentially costly new food security bill and reluctance to cut fuel subsidies, are expected to continue to weigh on its fiscal deficit.

The budget will be presented on March 16.

"There can be periods where downside risks and downward pressure on the currency remerge either because Europe flares up again and we are in a risk-off environment, or if inflation proves to be more sticky, or if the budget does not deliver in terms of fiscal consolidation," HSBC's Eskesen said.

(Editing by Tony Munroe and Ramya Venugopal)