Contrary to widespread view of depreciation, Indian Rupee (INR) has appreciated sharply by approximately 5 percent since the beginning of this year on robust foreign inflows and apparent change in RBI’s response towards fx management. INR rally was largely in sync with uptick in global exports and generalized EM basket appreciation against dollar. However, INR outperformed the peer EM basket given India’s benign macro-stability parameters, prudent fiscal and monetary policy, continued thrust on reforms and favourable long term growth outlook.Trump administration’s currency policy, improvement in global US Dollar (USD) liquidity, global reflation trade, uptick in world trade and stability in Chinese Yuan (CNY) were global tailwinds for stronger INR. Moreover, electoral victory by the ruling BJP in the recent state elections also boosted confidence on long term political stability and ability to push reforms like the Goods and Services Tax (GST), thereby boosting confidence on Indian assets. We believe that the optimism surrounding Indian economy and the prudent monetary/fiscal policy should result in India continuing to see a rising share of global capital.
Change in Reserve Bank of India (RBI) stance: RBI’s comfort and relatively muted intervention amidst sharp appreciation towards 64 levels caught market players by surprise, and was an important reason for the sharp appreciation in currency. We believe that there is a stronger case for central bank intervention in fx market on the face of strong capital flows and we have to see whether the recent laissez faire approach reflects a fundamental shift in RBI’s approach or is just temporary fallout of the current liquidity scenario.Absent RBI’s anchor, INR is likely to be much more market determined with on an average higher volatility than what markets have got used to over the last 3 years. Decline in RBI’s role in fx market is likely to result in higher volatility in USD-INR and hence the possible range of outcomes is likely to widen.
INR overvaluation is unsustainable: INR is currently at overvalued levels on relative as well as absolute basis which is beginning to negatively impact trade deficit. This sharp appreciation in INR on the back of capital strong inflows without any significant improvement in relative productivity is likely to be detrimental for India’s external balance sheet with exports and current account likely to be impacted negatively. We also note that India continues to run current account deficit and has a large liability position in International Investment Position, which creates long term sustainability issue.Moreover real exchange appreciation is a form of monetary tightening at a time when domestic demand remains weak, inflation is trending down and credit growth is hovering close to all-time lows.
Strong currency is its best antidote: We note that the change in RBI stance disconnects the link of USD-INR with Real Effective Exchange Rate (REER) based valuations in the short run. However, in the longer run, unduly strong currency sans material change in productivity tends to self-correct through weakening external account. However, this self-correction is generally more volatile with potentially negative impact on the economy.
INR Outlook: Our long term view is for INR to ultimately self-correct, albeit with a lag. However, in the near term USD-INR is likely to be function of continuation of “Trump trade”, FII flows into Indian markets, and geo-political risk factors.We expect some depreciation in INR from current levels and we see USDINR in the range of 66.0-67.0 by the end of CY2017.
