5/3/2011

The Indian rupee rally against the US dollar is in trouble. At least for the interim.

Why?

On May 3rd , the Reserve Bank of India elected to raise rates by a full 50 basis points. The decision bucked earlier estimates of a 25 basis point increase and elevated the potential for trouble for companies dependent on capital lending. The rising cost of doing business in the country (as well as maintaining current lending obligations) will hurt the overall economy – which is expected to expand by a healthy 8-9% this fiscal year – as companies under pressure from higher rates trim spending. Current rate of growth helped central bankers in their most recent decision as the momentum in the economy continues to support consumer price increases of over 8.5% annualized. Companies like Mahindra&Mahindra (a tractor company) and ICICI Bank will see narrower bottom lines now as more funds are allocated to the firm’s capital cost structure.

And trouble due to higher lending costs to businesses is only the beginning.

Consumer spending is also likely to take a hit as banks and other consumer financial institutions make it more difficult to lend to retail consumers hungry to spend. With longer term retail growth trends expected to see upwards of 4% annually, current inflationary measures are likely to keep disposable spending minimized – lending to a lesser than 2% increase in growth in retail in the next several years according to an industry report. This will do nothing but take away from overall economic growth.

Both negative effects are supporting at least an interim pullback in the USDINR exchange rate – currently at 44.425. Although the long term bias still remains bullish for the Indian Rupee, the recent central bank decision is going to make investors think twice about going long INR – at least for the time being.