Historically, the movement of the rupee against the dollar has had a direct impact on the stock market, but over the last few weeks despite the rupee falling from 53.70 to a dollar to 56.58, the market rose nearly 10%. The pressure on the rupee has been a function of the current account deficit (CAD), which is expected to be 5% in FY13. The comfort level for the Reserve Bank of India (RBI) as far as the CAD is concerned is 2.5%. While some relief is expected in FY14 if crude prices continue to trade around the $100 level, does it justify the current rally? Why aren’t FIIs, who have traditionally  driven the market taking a more cautious stance?

So far, the RBI has been banking on fickle capital inflows to cover the deficit but how prudent is it to assume that the flows will continue. Despite getting flows of $11 billion in CY13, the currency has weakened but the market has paid little heed. Dharmesh Mehta, who heads the institutional equities desk at Axis Capital feels the weakening rupee didn’t dampen inflows for a couple of reasons. “An increase in India’s weightage in the MSCI Index meant more allocation.” The second reason he says, “New foreign investors are able to buy more for the same dollar.”  

The markets have now got so addicted to easy liquidity that any news of scaling back sends it into a tizzy. So, even though outgoing Federal Reserve chairman Ben Bernanke has indicated, “A premature withdrawal of stimulus efforts would put the economic recovery at risk,” the dollar has displayed unusual strength against other major currencies. “The last one month has been more about the strengthening of the dollar rather than the weakening of the rupee,” says Alchemy Capital’s chief investment officer Hiren Ved. “It is not just the rupee that has taken a hit, other Asian currencies have also lost ground,” he adds. 

Of course, if the weakening trend of the rupee persists, it will not only eat into the return of existing FIIs but put on hold new inflows. Alchemy’s Ved explains that foreign investors are assuming that the dollar will trade in the ₹ 53 to ₹ 56 range. “Anything below ₹ 56 is a warning sign which could affect the market negatively. If the rupee continues to depreciate, foreign investors will wait to see the lowest possible value it can hit.” The rupee breaching the 56 level and the RBI’s latest hawkish tone on interest rates has created a ripple and resulted in a 2.5% correction in the Sensex. A deeper cut looks likely to follow.