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Despite current appreciation against dollar, rupee may depreciate gently in 2018

The rupee's unexpected appreciation against the dollar ..

The rupee's unexpected appreciation against the dollar in the last few weeks has less to do with domestic events than the revival of a whole bunch of concerns about the US economy and currency. The dollar lost against almost all currencies, ranging from the euro to the Brazilian lira. The rupee's uptick is merely part of this momentum.

Alist of these concerns may be useful to gauge where things are headed. For one, there is the view that there simply isn't enough inflation in the US economy to warrant the three rate hikes in 2018 that the Fed has signalled.

Market participants believe that subdued inflation readings could prevent the US central bank from hiking more than twice. Higher interest ratesattract capital and support currency appreciation. As the market begin to price in smaller rate increases than anticipated earlier, it tends to sell the currency.

Moreover, markets fear that President Donald Trump may try to reshape the Fed's stance altogether. His bid to prop up growth has little room for an uncooperative Fed that poops the party by hiking interest rates to thwart long-term inflation pressure that high deficits are known to breed. The easiest way to do this would be to appoint 'dovish' candidates to the Fed's apex rate-setting committee, the Federal Open Market Committee (FOMC).

The change in composition could lead to a shift in the future trajectory of the policy rate. The new Fed chairman-elect, Jerome Powell, is known to be soft on inflation. There are four other vacancies on the Fed's sevenmember board of governors that Trump has to fill, all of whom would sit on the FOMC.

Besides, markets have over time become less sanguine about US growth prospects. Instead of the US powering global growth, they see a convergence in growth rates of the US, Europe, Japan and emerging markets. Going by the textbook, higher growth rates of an economy (than its trade and investment partners) tend to add to its currency's sheen. That seems to be fading somewhat rapidly.

Dolled-Up Dollar
This pessimism stems partly from a closer reading of the Trump administration's brand new tax plan. Analysts who have pored over the fine print point out that the tax cuts may not lead to significant gains for the average US taxpayer, and so, the pop in consumer demand could be muted.

The recent history of the dollar also shows marked investor aversion to rising debt and deficits. The currency rose sharply in the Bill Clinton period when the US consolidated its fisc and even ran a budget surplus for acouple of years. As the deficit ballooned under the George W Bush government, the dollar tanked against major currencies.

The Trump tax plan pencils in a large increase in deficit even under the most optimistic conditions. That's certainly not good news for the dollar.

Finally, the dollar ran up on the back of the tax Bill in the hope that repatriation by US companies back to the US would boost its demand. But much of the cash held by US companies overseas is already held in dollars or dollar-denominated instruments So, repatriation may entail fresh demand for the greenback.

Where do the dollar's woes leave the rupee? Does it mean our currency is on a solid track towards 60 to the dollar? Or will it depreciate over 2018? Two words become critical in answering this question: 'commodities' and 'liquidity'.

As global growth improves and stock markets across look overvalued, investors have started looking at commodities as the next big asset class to invest in. That, say, oil is trading steadily over $65 a barrel has much to do with investor support as with regional political tensions. Base metal prices moved up sharply in the second half of 2017 and are likely to rally further in 2018.

Thus, commodity exporters (e.g., Brazil, Malaysia, Russia) are, prima facie, likely to fare better than large commodity importers like India.

Global liquidity is likely to get a tight squeeze as the Fed contracts its balance sheet by selling bonds it bought under the three quantitative easing programmes, and both the European Central Bank and the British monetary authorities following in its wake. Globally, there will be less money for investors to play with. Emerging markets (EMs) were one of the biggest beneficiaries of the easy money regime. They are likely to see funds retreat as liquidity tightens.

Soft Slide
This may not happen uniformly across EMs. Put the commodity and liquidity stories together and commodity exporters could actually see money coming in, while capital could leave the shores of commodity importers, particularly those that run current account deficits.

So here's a likely scenario. In 2018, the dollar could lose against its peers in the G7 world as well as commodity currencies (the Brazilian real and the Australian dollar are classic examples), but gain against currencies like the rupee. Investors may put a premium on India's recent reform record, RBI's dogged fight against inflation, and its fabled domestic market. So, our currency may not be battered and bruised but depreciate gently. That might not be a bad thing after all. Ask any exporter.

(The writer is chief economist, HDFC Bank. Views are personal)

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