Weaker Rupee is vital to support exports performance in the near term. We expect Rupee to trade in the range of 68-69 levels by March-2017 and 70-72 levels by September-2017
The Indian Rupee has traded broadly in a range for the past few months now and has seen relatively lower volatility than most other currency pairs in the EM basket. In fact in REER terms, which is a broad gauge of a currency's competitiveness, the INR's overvaluation against a broad trade weighted basket has actually increased over the past few months. We have to remain cognizant of various factors which would affect Rupee trajectory currently and going ahead.
Factors in favour of INR: Fundamentals on strong footing
India now FII neutral: The Indian economy is now in a position to comfortably finance the current account deficit by stable flows (FDI etc.) alone without resorting to FII flows. Even with a modest FII inflow, India is likely to end the fiscal year with a comfortable balance of payments surplus.
Current account deficit narrowed significantly in Q1-FY2017: To further reinforce the position of strength, the current account balance data released last week posted a small deficit of USD 0.3bn. As long as oil prices remain favourable (our expectation: USD 45-50/bbl), our external balance is likely to remain benign.
The recent decision by the OPEC members to cut crude production by ~2% has the potential to raise crude prices, but still we believe that it will have limited impact on the external sector outlook. From a medium term perspective qualitative improvement in India's export basket is crucial to sustain recovery.
External vulnerability indicators show improvement: India's foreign exchange reserves are at record highs (~USD 370 bn), which also yields an import cover of ~12-13 months, a significant improvement from the lows of 7 months witnessed during the taper tantrum episode of 2013.
Factors weighing on INR: Global risk events to be watched carefully
RBI FX policy stance:The RBI has managed Rupee fairly strategically to ensure that volatility in the currency is curbed significantly without actually targeting a level. INR implied vols are some of the lowest in the basket of EM currencies. Going ahead, we expect the RBI and the Government of India to conform to a sort of a tacit agreement that a gradual calibrated depreciation in the Rupee is desirable from an exports competitiveness standpoint and hence we expect the broad trend to continue even against the backdrop of a regime change at the RBI.
However from a tactical perspective, the sensitivity of Rupee to capital flows have improved with the regime change at RBI. We think that the shift in FX intervention stance is opportunistic in nature and is aimed towards providing flexibility to market participants to garner Dollar ahead of FCNR (B) related payout over the next few months.
Global Central Bank policy:The US Federal Reserve is expected to increase its interest rate in December this year after a long hiatus of a year. While, the action will be adequately priced in ahead of the event but the Dollar index would appreciate in response and benchmark interest rates in the US would also rise thereby compressing the rate differential with India. This will be reinforced by prospects of rate cuts in India over the same period. Given this backdrop, capital flows may see significant volatility and weigh on INR trajectory.
Global policy fatigue and asset market dislocations:Other risk events which have to be watched for are the upcoming US elections and more importantly the growing sense that some form of fatigue is setting in among Central Banks as regards to the monetary policy.
We also note that almost USD 10 tn worth of global bonds are yielding negative returns. This juxtaposed with the fact that cross asset correlations are approaching unity, any kind of violent sell off in bond markets will trigger spillover reactions across other asset classes as well. In such a scenario, risky assets will be sold off and Rupee will also feel the heat. Rupee's sensitivity to the Asian currency index has gone up significantly.
Escalation in geopolitical tension to be closely watched:The rising tension between India and Pakistan recently has the potential to create volatility in the financial markets in general. The implications will be contingent on the duration of the military activity but from the markets perspective, it is likely to create overhang for the Indian Rupee in the near term.
Rupee to consolidate with a depreciation bias
Indian Rupee has depreciated only ~1.6% from the beginning of this fiscal and has also witnessed bouts of significant appreciation on the back of strong flows. Fundamentals are strong and may exert a strengthening bias on the Rupee. Nevertheless, we think a combination of global forces and a tacit preference for depreciation on the part of policymakers will cap any excessive appreciation pressures.
In the short term over the next couple of months, the significant FCNR (B) outflows from the economy will have to be watched closely. While we are sanguine that the process will be managed seamlessly by the RBI but any unforeseen temporary liquidity shortages in the Rupee or Dollar markets will adversely affect the Rupee in the very short term.
From a structural point of view, on the external sector front, muted exports sector performance as well as any rise in non-gold non-crude imports remain areas of concern. Over time, a weaker Rupee can act as a catalyst to revive exports sector performance.
India is relatively better prepared to handle the volatility as compared with the taper tantrum episode of 2013. On balance, we expect the rupee to trade in the range of 68-69 to the Dollar, with a depreciation bias by March 2017 and ~70-72 levels by September 2017. In a scenario of extreme forex market volatility, though the currency could overshoot the range, we expect it to revert to the mean from a medium-term perspective.
Please refer to the attached document for a detailed report.
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