What can turn the rupee around?

While there does seem to be some evidence that the RBI may have ventured back into the forex market last week to prevent further rupee strength, it is clear that it can no longer return to the blind dollar buying of the past few years.

The inflationary spurt and the continuing fear that prices may once again get out of control, particularly given global price trends, will keep the RBI deterred.

Thus, it would seem that only a substantive turnaround in the dollar's fortunes globally and/or a serious bout of emerging market risk aversion could see the rupee weaken, and indeed, prevent further rupee strength.

So, what is the likelihood of either or both of these happening?

First of all, relative to its history, the dollar remains quite weak - the dollar index is at 82.31, just a bit above its all-time low of 78.33 (set in 1993) - which would prima facie suggest that it should be turning around soon.

However, there are certain structural factors that could keep the dollar under continued pressure. For instance, the US is no longer the lead engine of world growth. Its pole position in incremental growth, which it has held since 1989, has finally been usurped by - you guessed it - China In fact, the BRIC countries contribution to incremental world growth will probably exceed that of the US from here on out.

This confirms that the period of global unipolarity - with the US not only the strongest country militarily but also the buyer of last resort - is over. This, in turn, suggests that the pressure on Asian (and other) exporters to support the dollar will continue to lessen, which will prompt an increasing diversification of reserve assets out of dollars.

There is already some anecdotal evidence of oil invoicing in euros and of several emerging market central banks diversifying their reserves holdings out of dollars. Indeed, this trend, which has been in place since at least 2001, has probably been responsible for a lot of the dollar's recent weakness.

The IMF has reported that the share of US dollars in total world allocated reserves (of about $1.6 trillion) has fallen from 72 per cent in 2001 to 64 per cent more recently. Over the next decades, we will likely see the creation of a three-cornered stool supporting world growth, reflected in the dollar, the euro and a basket of Asian currencies (including the yen, the yuan and, in time, the rupee), each taking a significant share of the world's reserve capital.

This would suggest that the long-term average holding of US dollar assets should not be much more than 40-45 per cent, which, if true, would point to continued structural weakness still ahead for the dollar.

Of course, during this long march downwards, there will doubtless be short-term cyclical forces that will interrupt the trend - that is the nature of markets. For instance, perceptions of likely interest rate changes could shift in the near future.

Currently, the market expects US rates to fall sometime later this year, while European and Japanese rates are expected to stay on hold or rise a bit. But markets are always looking ahead and it may well be moving its focus to where the non-US interest rate cycles peak and differentials again move in favour of the dollar.

Indeed, the dollar's recent mini-firmness may be linked to this changing perception. When this force does play itself out, we could see the dollar surprise on the upside, which, in turn, could provide some respite from the strong rupee.

Another more dramatic force that could affect the rupee is the possibility that the wild ride in global asset markets comes to a plunging end at some time in the future. The kind of price hysteria seen in a wide array of both standard and alternative asset markets has several analysts worrying that markets may be approaching a top.

Perhaps an old market aphorism: "sell in May and go away" may come into play this year. On the other hand, of course, these same analysts have been worrying about the market hysteria for years now, and it could well be a few more years before the asset bubbles finally burst - recall that the tech bubble burst more than three years after Greenspan raised his "irrational exuberance" concern; interestingly, Greenspan was talking about his concerns on China recently.

In any event, whiff [when/if] this cycle cracks, there could be a sharp increase in emerging market risk aversion, which could push the rupee lower, and perhaps, much lower.

The big problem, of course, is summed up in the word "whiff" in the last paragraph - no one knows the answer to that.

About all we do know is that rupee volatility is going to remain high. If the RBI improves its market management, we would be spared the sudden shocking shifts in volatility we have had to live with recently, but there will be times when the definitive up trend in the rupee breaks and it turns weak for long periods. Conversely, there will be periods of surprising rupee strength.

To live in this "real" world, companies need to develop a strong risk-focused MIS, which enables them to judge when to simply eliminate risk (by buying forwards or options), when to ride a winning position, and when to enter into structured products, which provide both some protection and some opportunity participation.