By Neelkanth Mishra

A run on a currency is not about the arithmetic of current and capital accounts. It is about psychology and mass hysteria. In the short term, it is nearly impossible to determine the fair value of a currency.

A currency will likely depreciate merely because most people agree it should, potentially triggering a vicious downward spiral. Unlike a physical commodity, a currency only has value because everyone believes it does. It is important to view the rupee's recent moves from this prism rather than to try to justify it with technical sounding phrases, such as "unsustainable Current Account Deficit (CAD)", "high inflation differentials", "falling growth differentials" and so on.

Last year's problem

To begin with, high CAD was last year's problem. This year, with imports falling, exports rising, remittances accelerating and software services starting to pick up after a prolonged lull, the CAD can be as low as $35 billion, well below 2 per cent of GDP, much lower than the $88 billion recorded last year. This level of CAD can be funded just with foreign direct investments (FDI) and non-resident Indian deposits: two sources of capital that are remarkably steady. Even if other sources of capital dry up, the rupee should stay stable.

That the CAD is falling is already visible in recent data. The trade deficit shrank dramatically in June and July to just above $12 billion a month from last year's average of nearly $7 billion a month and the peak of $21 billion a month. Remittances have accelerated significantly, and IT services companies are regularly reporting a pick-up in dollar revenues.

The disbelief among commentators stems from the fact that the recent trade deficit has moved in the opposite direction compared to previous crises of 1991, 1997-98 and 2008. Then, slowing global growth would hurt exports, but due to a resilient domestic economy, imports would stay high, widening the trade deficit. This time, there is domestic weakness for intrinsic reasons, and global growth is becoming more stable.

The trade deficit should shrink. With a dramatic slowdown in the power, steel and airline industries, the demand of imported equipment for steel plants, power plants and aircraft is falling. Excess domestic steel capacity is squeezing out imports. With the government raising fuel prices, higher prices are slowing demand, over and above the broader slowdown: oil demand is now falling. And there is a 3 per cent rise in exports in the last two months.