Currency

-An Analysis of Factors affecting it and trends

July 30, 2010

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Historical Movement of Currency USD/INR

Rupee on
depreciating
trend vs.
USD for last
3 months

Source: currenciesdirect.net

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Historical Movement of Currency Euro/INR

Rupee on
depreciating
trend vs.
Euro for last
2 months

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Historical Movement of Currency JPY/INR

Rupee on
depreciating
trend vs. Yen
for last 3
months

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Historical Movement of Currency GPB/INR

Rupee on
depreciating
trend vs.
GBP for last
2 months

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Factors affecting Currency

Numerous factors determine exchange rates, and

all are related to the trading relationship between
two countries.
Exchange rates are relative and are expressed as a
comparison of the currencies of two countries.

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Factors affecting Currency

Inflation Differential: As a general rule, a country with a consistently lower inflation rate
exhibits a rising currency value, as its purchasing power increases relative to other currencies.

Interest Rate Differential: Higher interest rates offer lenders a higher return relative to
other countries. Therefore, higher interest rates attract foreign capital and cause the exchange
rate to rise.
Current Account Deficit: A deficit in the current account shows the country is spending
more on foreign trade than its earning and that its borrowing capital from foreign sources to
make up the deficit. The demand for foreign currency lowers the country's exchange rate.
Balance of Payment (BOP): Countries will engage in large-scale deficit financing to pay for
public sector projects and governmental funding. While such activity stimulates the domestic
economy, nations with large public deficits and debts leads to inflation leading to devaluation
of rupee. The debt is reflected in Indias BOP.
Economic Performance & Political Situation: Foreign investors inevitably seek out
stable countries with strong economic performance (strong GDP, Foreign Reserves, IIP etc.)
in which to invest their capital. A country with positive attributes will draw investment funds
thereby being favorable to the domestic currency

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Inflation

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Inflation

Indias inflation in June 2010 was at 10.55 % (from 10.16% in May, 2010), a very high rate
mainly due to food price inflation.

Inflationary situations in India have historically been preceded by food price increases.
High food prices exercises a cascading impact by pushing up wages and other costs. All this
gets magnified in a growing economy, where incomes are rising and in turn, translating into
higher purchasing power.

Inflation is today a structural problem that can be fixed by addressing supply side
constraints in food - both on the production as well as distributional logistics fronts. The
increases in fuel is likely to push it further. State Governments are also unable to control the
supply of food due to rains.

On July 27, 2010, RBI Governor maintained that the headline inflation is likely to ease into
single digit over the next 2-months on the back of a normal monsoon and lower global
commodity prices. But industry bodies like Assocham believes the inflation is going to increase
further.

The Governor however, cautioned that the wholesale price inflation could stay in "high single
digits for a while" despite a likely easing, before cooling down to 6% by end-March, 2011.

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Historic Inflation Rate

WPI Inflation Rate

Inflation is now
above double digit
Although the
inflation turned
negative in July
09, the consumer
prices has been on
the uptrend in
India (currently at
14%)

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Consumer Price Index - Comparatives

Indian
Consumer Price
Index is much
higher than
other remerging
countries

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Interest Rates

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Interest Rates

In July 27, 2010 Credit Policy, RBI has hiked its overnight lending rate or repo by 0.25 %
to 5.75 % and its borrowing rate (reverse repo) by 0.5 % to 4.5 %.

RBI lifted its benchmark rates for a 4th time this year on July 27, 2010 to contain the
runaway inflation, hovering above 10 per cent for the last five-months. WPI-inflation
stood at 10.55% in June.

It has raised interest rates more aggressively than expected on July 27, 2010 to fight
inflation that is on double digits for a sixth straight month, setting the stage for more
policy tightening.

RBI and the government of India are deliberately ensuring tighter liquidity to keep the
money in circulation low, and hence trying to keep inflation under control.

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Historical Repo Rate (%)

Historical Bank Rate (%)

9.00

8.00
7.75

7.00
6.00

7.75

6.50
6.00

5.75

5.00

5.00

4.75
4.00
3.00
2.00
1.00
0.00
2005

2006

2007

2008

2009

2010

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2011

Significant
tightening by
RBI during
2010 in 4
steps.

Current Account Deficit

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Current Account Deficit

The current account posted a $13 billion deficit in Q1, 2010 after $12.2 billion shortfall
in the previous quarter.

A widening current-account deficit may weaken the rupee further, already the worst
performer in Asia this quarter after the Korean won.

Imports rose 43 percent to $83.9 billion while exports grew 36.2 percent to $52.4 billion
Q1, 21010, leaving a gap of $ 31.5 Bn

Inflows from invisibles (includes software export and remittances )were $18.5 billion in
Q1, 2010, less than $18.9 billion in previous quarter, resulting into a trade deficit of $13
Bn.

Current account deficit has been widening since the 1st quarter of 2009, resulting
into serious concern that it will continue to deteriorate, and eventually weigh on the
rupee.

As per analysts, India's current account deficit has reached levels that are now a
material influence on the currency.

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Historical Current Account Deficit

Current Account Deficit ($ Bn)

45.00
40.00

38.40

35.00
30.00

29.00
25.00
20.00
16.00

15.00
10.00

Current
Account Deficit
increased to
2.9% of GDP in
FY10 from 2.4%
in FY09.

10.00

5.00
0.00
FY07

FY08

FY09

FY10

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A deficit in the
range of 3% of
GDP is quite a
concern.

Balance of Payment

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Balance of Payment (BoP)

BOP: It is sum of 1) Capital Account Surplus/Deficit + 2) Current Account

(Surplus/Deficit) + 3) Balancing Item (Accretion/Decretion to reserves).

BOP recorded a small surplus of $1.8 billion in Q4, 2009, compared to surplus of $9.4
billion recorded in the previous quarter. This is mainly due to a slowdown on the
capital account side. The current account was largely in the same range.

The lower capital account surplus is largely on the back of lower FDI and portfolio
inflows.

The current account deficit, however, weakened further on account of lower earnings
on the invisibles account (like software exports) although the trade deficit
improved on account of faster fall in imports as compared with exports.

Slowdown in FIIs and FDI are key concern. Going forward, the global risk
appetite would be extremely crucial for FII flows. FDI trends are likely to be more
resilient unless there is a fresh bout of global uncertainty.

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Historical Balance of Payment

sharp decline in
capital account
surplus.
Current account
deficit in the range
as previous
quarter.

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GDP

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GDP

The Indian GDP at $1159 Bn, is predicted to grow 8.8% in 2010 as forecasted by IMF

"For the first time it appears entirely within the realm of possibility that India will break
into double-digit growth within the next five years Finance Minister

India's economy, which grew at an annual rate of 8.6% in the first three months of
2010, has been fuelled by strong Domestic Demand and Export.

The better than expected performance aided by significant fiscal stimulus and loose
monetary policy in recent past.

Two stimulus packages providing tax cuts and increasing infrastructure spending
in connection with lower interest rates have supported significantly domestic demand.

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Historical GDP Growth Rate

The GDP growth in Q1

2010 is 8.6%

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Index of Industrial Production (IIP)

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Index of Industrial Production (IIP)

India's industrial output rose up to 11.5% in May 2010, compared to the previous
month growth at 16.5%.

Capital goods production dropped to 34.3% in May, 2010 compared to 72.8% in Apr.

As many as 15 out of the 17 industry groups showed positive growth during May 2010
compared to the corresponding month of the previous year.

The industry group metal products and parts, except machinery and equipment'
showed the highest growth of 39.8%, followed by 'other manufacturing industries'
(27.6%) and 'jute and other vegetable fibre textiles (except cotton)' at (26.9 %).

As per the Government, given the pattern of corporate results which have been
coming in and the IIP figures, the growth trend of IIP will continue.

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IIP Historical Growth Rate

IIP growth in May

2010 at 11.5%

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Foreign Exchange Reserves

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Foreign Exchange Reserves

Indias foreign exchange reserves comprise of 1) foreign currency assets (FCA), 2) gold,
3) special drawing rights (SDRs) and 4) reserve tranche position (RTP) in the
International Monetary Fund (IMF)
Forex reserves stood at US$ 283.5 billion at the end of December 2009. It was US$
252 billion March 2009, resulting into an increase of US$ 31.5 Bn.
35.6 % of this increase i.e. US$ 11.2 Billion was attributed to higher inflows under
FDI, and portfolio investments
64.4% of this increase, i.e. US 20.3 Bn is attributed to valuation gain due to a weak
US dollar against major currencies. In this way credit for two out of every three of
these dollars go to the rupee appreciation.
As of December 2009 India's had 5th largest Forex Reserves in the world.
2009-10 saw India becoming the world's 10th largest gold-holding country. The
government's purchase of 200 tonnes of gold from the IMF in 2009 took its total
reserves to 557.7 tonnes, or about 6% of total foreign exchange reserves.

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Foreign Exchange Reserves Trend

Forex reserves
on the rise since
FY09

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Forecast Indian Rupee

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Forecast by Stewart Newnham & Yee Wai Chong,

Strategists, Morgan Stanley July 26, 2010

Morgan Stanley is bearish on Indias rupee on signs the economy is slowing.

It says that the rupees economic fundamentals are deteriorating as growth slows, the
balance of payments declines and because monetary policy may not be
sufficient to temper inflation.

As per the forecast, three of the rupees fundamentals are softening: macro- dynamics,
balance of payments and monetary policy credibility.

The currency was ranked by economists at the start of the year as Asias second-most
promising for 2010. Instead, it has dropped 1 percent, the second-worst performance
among Asias 10 most-active currencies after South Koreas won.

Morgan Stanley has revised down its 2011 GDP forecast to 8.4 percent from 8.8 percent. It
says if the RBI delays its tightening, then this would immediately confirm its bearish view
on the rupee. Even if the central bank raises rates, it does not cancel its confirmation
signal outright, rather only postpones it.

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Forecast by Gaurav Kapur, Senior Economist, RBS

-July 26, 2010

The rupee remains on a back foot following a rising merchandise trade deficit
and slower pace of capital inflows. Trade deficit for the first quarter of the current
fiscal year climbed to $32.2 billionalmost $10 billion a month.

In order to fund this deficit, net capital inflows and services exports of almost equal
measure are required. Even though capital inflows from the FIIs remain healthy, other
sources of capital arent showing any major signs of pick-up.

In that context, the monetary policy announcement by the RBI on July 27, 2010 assumes
significance.

Predicting that recent volatility in such flows will continue or even increase, RBS
anticipates that the rupee may "languish" in the 46 rupees-47.50 rupees range over the
next three months, with an upside bias for the dollar.

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Forecast by Philip Wyatt, Economist, UBS

-July 20, 2010

Indias economy and markets may be tested by slowing global growth as the South Asian
nations industrial momentum peaks.

Economic growth in 2011 to 2012 may ease to 8% from an estimated 9% this year. Indias
currency and equities may face severe turbulence in the second half given the need to
bridge a current account deficit that widened to a record $13 billion in Q1, 2010 amid
slowing global growth.

For the past year domestic factors have dominated: the vigorous rebound, the inflation
concerns.

Inflation is accelerating amid the economic rebound and governments increase of fuel
prices of state-run refiners.

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Forecast by Standard Chartered

-July 14, 2010

The trend in the trade deficit is worrisome and has increased the downside risks to
India's balance of payments. This does not bode well for the Indian rupee outlook.

StanChart downgraded its forecasts for the rupee earlier this month and now anticipates
the dollar may rise to 47 rupees by the end of September.

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Forecast by Dariusz Kowalczyk, Credit Agricole

-July 20, 2010

The outlook for higher rates will support the rupee in the near term.

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Forecast by Rahul Bajoria, Economist, Barclays

-July 14, 2010

Rupee will continue to underperform.

The risks of a weaker rupee in the medium term are high because the current-account
balance looks set to deteriorate further.

Barclays predicts Indias annual current-account deficit will widen 15 %, to $44 billion,
in FY11.

Note: Barclays is the worlds third largest currency trader

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Rupee Forecast - Summary

Firm

Outlook

Concerns

Morgan Stanley

Bearish

Slowing growth, BOP problem, ineffective monetary

policies

Royal Bank of Scotland

Bearish

Trade deficit, slower capital inflows

UBS

Severe
turbulence

Inflation concerns, slowdown in global growth

Standard Chartered

Bearish

Trade deficit, Balance of Payment

Credit Agricole

Support in
short term

Interest rate hike by RBI to support rupee in short

term.

Barclays

Underperform

Current account deficit.

There is a view that rupee will touch 47.0/47.5 by September, 2010

from current level of 46.56 (July 29, 2010)
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Euro vs. USD

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Historical Movement of Currency USD/Euro

Euro on
appreciating
trend vs.
USD for last
2 months

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Outlook for US Dollar

The recent disappointing data on US Economy (durable goods) led to dollar falling
against the Euro and Yen indicating that US recovery is slowing.

US economy lost twice as many jobs in July 2010 as expected pushed the currency to its
weakest level in almost 4 month. Non-farm payrolls fell by 131,000 in July, while private
sector hiring was a tepid 71,000, triggered a fresh slide in the dollar.

This has drawn investor attention to the U.S. economy, taking the focus off the eurozone's sovereign-debt worries. According to Brown Brothers Harriman Analysts, the
U.S. data may not be helpful for the dollar near-term.

Demand for U.S. manufactured durable goods slid in June for a second consecutive
month, a sign the manufacturing sector expansion is slowing.

There is a concern that the U.S. could dip into another recession. The market is
struggling to find direction overall. There is an ambivalence between the double dip
or global recovery at the moment.

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Outlook for Euro

The Europe's economy is looking up with upbeat economic signs -- including robust
German business confidence, predictions of stronger second-quarter growth
and successful bond auctions by financially shaky Greece, Portugal and Spain.

In a recently concluded stress tests" designed to analyse how Europe's banks would cope
with a deepening economic and debt crisis, it was found that the regions lenders need to
raise 3.5 billion euros ($4.5 billion) of capital, about a tenth of the lowest analyst estimate.

Goldman believes that the risks are more manageable than they were, citing Europes BOP
surplus and the transparency of the stress tests as evidence. As a result, Goldmans 2010
GDP growth forecast for the Eurozone is above consensus at 1.4 %.

There is now substantial policy support for eurozone sovereign debt, along with data
suggesting that major eurozone countries maybe in a much better shape than feared.

Although whether Europe has truly put behind it for good the fears of the past few months is
still a matter of debate. Many governments have large debt piles that will take years of careful
financial management to cut down to size. Fixing public finances in the eurozone's more
troubled countries and unwinding their debt is a multiyear process.

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Historical Movement of Currency USD/YEN

Yen on
appreciating
trend vs. USD
for last 3
months and
overall
appreciating
trend for last 3
years

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Historical Movement of Currency Euro/YEN

Yen on
appreciating
trend vs. Euro
for last 3
months and
overall
Stagnant for
last 2 years

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Outlook for Yen

The yen has already strengthened beyond the trading levels assumed by most
Japanese auto and electronics makers.

Investors generally turn to yen-denominated assets because they're considered a safe

place to park money during global economic uncertainty.

If it holds at current levels or gains even more against the U.S. dollar and the euro,
Japan's biggest exporters may have to scale back expectations of an earnings recovery.

If Yen appreciates more, Japan's economic recovery, which has largely been fueled by
rising demand for Japanese products abroad, could be at risk

This has prompted Japanese politicians and business leaders to grumble about the yen's
strength.

The Ministry of Finance is yet to order the Bank of Japan to step into markets. But the
Japanese government hasn't intervened to ward off yen strength since 2004.

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Thank You
Swapan Kumar Das
swapankdas@gmail.com

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