Bitcoin has become the barometer of outflow from China. Over the past 24 months, wealthy Chinese have been moving money out of China, and now the flu has caught middle China too. Chinese authorities’ attempts to postpone the day of reckoning by continuing with their debt fuelled reflationary policies have made Chinese economy dangerously lopsided and financial sector crises prone. We have been bearish on Yuan since early 2015, citing that a weak currency is an inevitable fallout of their economic path and divergent monetary policy path of Fed and others. Since then, Yuan has weakened by 15% against US Dollar. We continue to see further depreciation in coming days.
Bitcoin has been on an upward trend, primarily driven by demand from Chinese, looking to hedge against a weak Yuan and low domestic deposit rates. With outflows running at over half a trillion dollars this year, if it had not been for relentless intervention from the Chinese central bank, Yuan would have depreciated far more than 6.96/97 levels, it is currently trading at against the US Dollar. However, selling dollars and buy Yuan to prop up the value is not without cost. As the Chinese central banks intervenes it tightens the supply of Yuan flow into the economy, thereby tightening monetary policy. They have been able to offset that by keeping rates capped and stimulating the economy using fiscal levers. However, the relentless stimulus flow since 2009 has increased leverage in the system to astronomical levels, which is now well over 350% of GDP as per some private estimates. Productivity of debt has collapsed, as it takes nearly 4 dollars of debt to create a dollar GDP, a level which if continued can trigger a financial crises down the road. China needs to rebalance its economic engine, away from production and investment to consumption and also needs to bring down leverage. Both these steps would have to done over long period of time and would weaken growth for a long time.
In the pecking order of currencies in the emerging market basket, Rupee has moved places in 2016. In Between January to October of this year, Rupee was one of the underperformers. It had weakened against 18 of the 23 major EM currencies. INR underperformed inspite of a sizable portfolio inflows. However, post demonetisation, there was a sea change in performance. The local unit gained against 20 out of 23 key emerging market currencies. This kind of a performance is truly spectacular considering that Indian capital markets, both bonds and equity, suffered the worst outflow in Asia. This perplexing behavior of Rupee was made possible by intervention from the central bank.
Between end of 2015 and end of October 2016, FPIs had bought USD 7 billion (net) of stocks and bonds from Indian capital markets. However, that was dwarfed by the USD 16/18 billion of dollar purchases by RBI from the open market to build its reserves. As a result, Indian Rupee not only depreciated against the US Dollar, but it also underperformed against its peers in the emerging market. Things changed when RBI reversed its role from being a buyer to a seller post demonetisation. Post November 8th, RBI’s FX reserve is down nearly USD 11 billion, primarily due to sales of USD in the spot market. Anecdotally we can say that RBI was also active in the forwards and futures market too, selling USD and preventing it from appreciating against US Dollar. During that same period, FPIs sold between USD 11/12 billion in local stocks and debt market. Therefore, it can be said that RBI more than compensated for the purchases of dollars by FPIs. End result was Rupee clocking a significant improvement in performance post November 8th.
In 2017, there are two variables to consider when deciding upon what the Rupee might do in 2017. One, the broader trend of US Dollar and finally, what will RBI do in the market. Our expectation is that the broad trend of US Dollar would be upward, primarily due to US first policy of Trump administration as well as divergent monetary policy path between US and rest of the world. As far as RBI goes, they would look to shore up the reserves in the first quarter of 2017, after a near USD 11 billion depletion in Q4 CY16. Therefore, it can be concluded that in first quarter of 2017 or at most during first half of 2017, Rupee may weaken past 70 mark against USD.
Apart from RBI, we need to keep an eye on the following major events which would also have an effect on Rupee, stocks and bonds. They are:
1) Demonetisation is a part of a larger plan to formalize the economy and GST is a step towards a needed tax reform. However, post require a cost that the economy must pay during the transition phase, by way of demand and jobs. We believe it is a medium term pain for the long term gain of the nation.
2) Oil and commodity prices are not at levels where it can threaten either inflation or current account. Hence they are not a major driving factor for Rupee as of now. We expect non-agri commodities, including oil to remain in a range for 2017 and hence should not post much of a threat to Rupee.
3) The theme for 2017 will be Mr. Trump and how he shapes the policies of US government, both, domestic as well as foreign. Certain policies are being talked about are:
Border tax proposal: Under which they would look to tax imports and make export earnings tax free. If such a plan is enacted it can throw a spanner into the wheels of global trade. Such a step can adversely impact economies in EM, esp of China.
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Tax amnesty scheme: Under this US corporates would incentivized to repatriate trillions of dollars of profits from offshore destination at a very low tax rate.
Fiscal stimulus plan: This can raise public deficit and push US bond yields upward
Protectionist policies and anti-offshoring policies: These can adversely impact China and other EMs. India can get affected, if the anti-offshoring policies focused on ITES and Pharma.
The new bonhomie with Russia will reshape global geo-politics, at the expense of Middle East and Europe.
4) Apart from Trump, the next big player in 2017 would be Europe. People in Europe will head for polls in major countries from France, Hungary, Italy and Germany. Markets will react negatively if Euro skeptic parties win in any of these countries.
Technically, the pair has spent almost a year consolidating. After a rapid rise during 2015, consolidation was warranted. Unless, the dynamic changes for USD vs EM currencies in 2017, there is real possibility of a resumption in the uptrend in USD/INR in 2017. Demand zone, defined by annual average and trend line is placed between 66.50/67.00 regions. However, USD bulls need to eclipse the supply closer to 69.00 handle. Incase of a clear break above 69.00, can bring about 70.50/71.00 in focus.