The Rupee should weaken against the dollar

There has been considerable realignment of the major world currencies in the last three months. While the G7 finance ministers and central bankers took note of these changes last week, they singled out the Chinese yuan as the one needing greater flexibility, possibly because it remains almost firmly tied to the dollar and, as such, does not reflect the new 'fundamentals' of the Chinese economy.

The movement in other currencies is significant. The US dollar fell 6.5 per cent against the euro since October 13. The fall was mainly due to US inflation, which is currently at 2.5 per cent. Trade deficit is excessive and a slow down in the economy has begun, led by the housing sector. After 17 successive increases the Fed interest rate stands at 5.25 per cent, the highest among the developed countries.

A more glaring and sudden fall was that of the yen. With the Japanese economic recovery, the Bank of Japan had increased the rate of interest to 0.25 per cent, the highest since 2001. The investors were expecting more. They have now discovered that it is good business to borrow in Japan and invest in other countries where the interest rates are high. Huge investments have gone to New Zealand where the interest rate has peaked at 7.5 pc. This ‘carry trade’ and ‘one-way bets’ in the currency market brought about the fall of the yen.

The euro and the pound hardened against the dollar and the yen. The European Central Bank increased the rate of interest six times since December 2005 taking it to the current 3.5 per cent level. The ECB is much more sensitive to inflation than even the US Federal Reserve. Besides, the EU economy has been performing fairly well though the threat of inflation persists and the March 8 ECB meeting mostly likely further jack up the rate of interest. The UK has already hiked its rate to 5.25 per cent, brining it at par with the US rate of interest.

The G7 took note of the softening of the yen but did not comment. For one, it is because the Bank of Japan Chairman agreed to seriously consider an increase in rates at the next bank meeting. There will most likely be a rate hike because more recent data do not signal any demand pressure and a rise in interest rate may reverse growth. The yen, therefore, will not recover soon. Similarly, the dollar may remain stay put since the Federal Reserve is unlikely to step up the interest rates. As such the euro will harden further against both the yen and the dollar.

In this currency muddle, the behaviour of the rupee has been rather strange. Most other countries, including China, are taking utmost care to stop inflation from crossing 2 per cent. Going by 6.5 per cent inflation in India, the rupee should have actually weakened. But in reality, it hardened 5.9 per cent against the dollar since August, in contrast to the inflexibility of the yuan.