Rupee is the leader of the emerging market pack, strengthening close to nearly 7% over the past three months. Many market participants have been surprised by Rupee’s strength but not me. Readers are aware that we had warned that Rupee could be in for more gains as the fundamental backdrop is positive for the local unit. Infact I am kind of taken by surprise that very few in the market noticed the shift in the real rate scenario back in February, when RBI turned relatively hawkish. They doubled down on that last Thursday, when they hiked the reverse repo by 25 bps. This change in stance provided the nitro boost to the Rupee carry trade.
In the market, there is a tendency to use a narrow scope of the US Dollar to measure how well the currency is fairing. It is a flawed way to do so. We need to compare Rupee against a basket of currencies, especially the other EM currencies. My Bloomberg terminal clearly shows that there has been a tectonic shift in how in Rupee’s performance against the peers before 2013 and after 2013. Between the years of 2011 to 2013, high inflation and low real rates add to that the growing economic and political risks, made Rupee one of the worst performing currencies in the emerging market space. However, with Dr. Rajan taking control of the monetary policy and Mr. Modi taking control of the India’s political leadership, things changed dramatically for the currency. Indian Rupee became the best performing currency in the EM space. However, between the months of May 2014 to January 2017, Rupee’s strength was hidden from the eyes of those who used the USDINR scope to measure its performance. A super strong US Dollar overseas, due to divergent monetary policy as well as an aggressive dollar mopping exercise from RBI did not allow for the Rupee to appreciate against the US Dollar. However, the extent of Rupee’s depreciation was much less than our peers, making us the strongest currency in the basket.
Between December quarter of 2013 to December quarter of 2016, net capital flows, was around USD 190 billion. Over that same period RBI bought foreign currencies, mostly US Dollars, between USD 95-100 billion. The difference between what RBI bought as foreign currency and what came in as foreign currency inflow became the current account deficit. However, inspite of the surge in capital inflows failed to appreciate the Rupee against US Dollar, even though Rupee gained ground against its EM peers and even against most of the other DM currencies. It was due to the relentless surge in the US Dollar globally. Stronger US Dollar overseas as well robust intervention from RBI kept the Rupee weak against USD. In accounting identity to link trade and capital flows of a nation, current account balance and capital account balance should cancel each other out to zero. Therefore, if a nation receives massive capital inflows and the central bank does not export back the capital through intervention in the currency market, its currency has to become stronger.
Year till date, RBI has accumulated close to USD 10 billion in the reserves. However, data from NSDL shows, FPI have poured in close to USD 13 billion over the same time period. Now consider other major sources of capital inflows like FDI and commercial credit, it becomes clear that RBI’s intervention has not been enough to mop up the excess capital inflows. Therefore, it is no surprise why Rupee has strengthened against the US Dollar and even against other currencies.
Two question come to mind:
1. What triggered the change of heart of the foreign investors?
2. How come, RBI has not been able to mop up entirely the excess capital inflows?
What can change the direction of USDINR?
What triggered the change of heart of the foreign investors?
A foreign investor, investing into interest bearing security is seeking risk adjusted return on his foreign currency investments. The major risk to that investment is the currency risk. Therefore they are sensitive to any factors that can trigger Rupee depreciation. They are:
1) Low interest rates relative to inflation and high inflation expectation.
2) Political risk
3) Economic risk
Tide changed for the Rupee on February 7th, when RBI changed its stance on monetary policy. RBI turned hawkish and signaled an end to its campaign to stop lowering interest rates. Such a move caused market driven interest rates to spike up. Higher interest rates and lower inflation expectation, improved the appeal of Rupee for the carry traders. As a result, nearly USD 6.5 billion flowed into the Indian debt market from foreign investors.
Inflows into the equity market also picked up, thanks to the relentless effort from the Modi government to make India an attractive investment destination. Emphatic win for BJP in the recently concluded state elections provided further bullish momentum to the equity markets.
Indian Rupee is benefitting from a hawkish central bank committed in keeping real rates positive and carrying out financial reforms and also a government determined to follow a conservative fiscal policy. Add to that reform oriented approach of Modi government and we have a too good to resist carry play for the global speculators.
How come, RBI has not been able to mop up entirely the excess capital inflows?
Post demonetisation banking system is flush with deposits. Low credit growth and surge in deposit growth has led banks depending on RBI to lend their excess liquidity. It is estimated that between 3 to 5 lakh crore of excess Rupee liquidity is sloshing in the interbank segment. RBI is unable to mop up the excess liquidity as it entails a significant cost on their books. The cost can be around 2 to 2.5 thousand crore per month in paid interest cost. RBI is reluctant to add to that sea of liquidity by intervening aggressively in the spot market to buy US Dollar. It is to be noted that for every 1 billion USD they buy, they infuse around 6400-6500 crore Rupees into the system. A combination of huge Rupee liquidity and significant influx of US Dollar into the system came as perfect one two punch for the US Dollar.