What a week it was for the Rupee bulls. Currency zoomed against the US Dollar and well past its peers to clock a gain of 2%. Since the early part of the year I have been warning that a weak US Dollar is coming.
What a week it was for the Rupee bulls. Currency zoomed against the US Dollar and well past its peers to clock a gain of 2%. Since the early part of the year I have been warning that a weak US Dollar is coming. Much of it due to Trump’s administration effort to score economic gains from a weak currency. However, the strength in the Rupee since the end of 2016, in which it rallied by 4.14% against USD, is mostly due to internal factors. In this piece I will focus on factors that are driving a structural rerating of the Rupee.
There are multiple frameworks to explain as well as forecast the value and direction of the real value of a fiat currency. They are termed as international parity conditions. However, none of them work all the time. If they did, then students of economics would concur, that making money out of currency trading would become a forgone conclusion. At the same time, it must be acknowledged that understanding these relationships and various other currency models, would help us create a framework which can offer, at least qualitatively, the factors that can drive the real value of a currency.
I will talk about three major factors to understand the structural strength or weakness in the real value of the currency. Remember, when we refer to real value, we strip out the effect of inflation from the argument. However, generally speaking, the direction in the nominal value of a currency pair would not be much different from the real value of the currency pair, in this case USDINR.
For most of us, we are so hooked onto the value of USDINR that we miss the larger strength and weakness of Rupee through the lens of other currencies. How well Rupee is doing needs to be judged from a broad scope, than from a narrow one like USDINR. There has been a sea change in the way behaved before September 2013 and how it fared afterwards. That is the month, when Dr. Rajan took over as the Governor of the RBI. The two critical factors that brought about the change in performance of Rupee were the change in thinking at the RBI at how it manages the value of Rupee and the political change that happened at the center.
The three factors are:
Real interest rates
Higher productivity boosts the long run competitiveness of a currency
1. Real interest rates:
Higher the high real rates for a nation, the more attractive the currency to foreign investors. Real interest comprise nominal interest and inflation. Markets are driven by current as well as future expected direction of nominal interest rate and inflation of a country. In India, since the days, Dr. Rajan became the governor, RBI has ensured that real rates on Rupee stay positive. That has helped the currency remain strong at a time when EM currencies have been battered by weak growth, rising rates in US and exceptionally strong US Dollar overseas. Inflation expectation has come off in India, as both RBI as well a government walked the talk on enacting policies that promotes low inflation in the country. Higher the inflation expectation, the more cagey foreign investors investing in a country, as higher inflation corrodes the value of a currency. Hence, by keeping monetary policy neutral and inflation expectation low, Indian Rupee has remained strong and stable.
2. Risk Premium:
Indian policymakers are encouraging an economic environment that promotes price stability and long-run growth. At the same time a robust political environment allows for bold economic reforms. The recently concluded state elections have significantly boosted the political capital of the Namo Govt. These are encouraging signs as India, after a long time, is being run by a leader who wants to push ahead with changes that can significantly boost long term growth for the nation. India boasts of a stable financial system. The bad debt problem in the banking system though remains unresolved but progress has been made in recognizing the issue. As a result, risk of a contagion remains low.
Over the past 40 months, RBI has changed the way it intervenes in the foreign exchange market. Previously it used to intervene either to shore up reserves or to douse fire when Rupee was caught in a free fall. RBI has adopted a dirty float currency regime, where they intervene on a regular basis, buying and selling to keep the volatility low.
Watch this also:
Low incidence of high downside volatility in INR and policies to improve the quality of growth in the country should continue to encourage investors to gradually demand a lower risk premium to hold the high-yielding Rupee assets.
3. Higher productivity boosts the long run competitiveness of a currency:
An improvement in the long run competitiveness of India is paramount in ensuring that real appreciation of the Rupee can be absorbed by the economy and financial without causing destabilizing boom and bust cycles that we are accustomed with currencies in the emerging market. Long run competitiveness is boosted by improving productivity of a nation.
A nation can become productive by improving the social capital and political capital of a country. From economics 101, we understand that a country can develop or achieve higher growth per capita or person is by increasing capital stock per person and also fostering innovation and risk taking. However, in order to absorb physical capital efficiently and also promote a culture of innovation and risk taking there is a need of high “social capital”.
World Bank defines social capital as: it refers to the institutions, relationships, and norms that shape the quality and quantity of a society’s social interactions. Increasing evidence shows that social cohesion is critical for societies to prosper economically and for development to be sustainable. Social capital is not just the sum of the institutions which underpin a society – it is the glue that holds them together.
India is making strides in improving its social capital by making its bureaucracy accountable and efficient. At the same time, moves are being made to further strengthen financial institutions, regulatory bodies and tax and corporate laws. Judicial reforms are being talked about as a way to improve India’s attractiveness as an investment destination. There is realization, even at the state level political establishment, that a pathway to re-election is through economic development. The common threads that is connects the hearts and minds of billion Indians are aspirations towards a better future. The force is becoming so powerful that is cutting across lines of ethnicity, caste, colour, sex and religion. It is remarkably encouraging sign for a nation, when political imperatives and economic imperatives converge.
Mr. Modi and his team is working tirelessly, even at the expense of political harm, to improve increase the size of formal economy and reduce the size of informal economy. Crusade against black economy is being waged on many fronts. As the economy of India will formalize, it will be become more efficient as credit penetration will increase, cost of capital will fall and investment in human capital will increase.
Though India still has a way to go to strengthen property rights and simplify tax laws and commercial laws to ease doing of business in the country. However, the political establishment remains committed, to make it easier for businesses to come up, prosper and wind up. India is fast emerging as a major destination for start-ups. At the same time, government is working to make it easier for all Indians to participate in the growth of the nation. An inclusive democracy that strengthens the rule of law will significantly improve the social capital and hence the long run competitiveness of its currency.
The analysis would not be complete if we do not bring the global market into the picture. US Dollar has not gone anywhere over the past couple of months. US Dollar longs had become crowded and on top of that the new political power in US keeps on making dollar negative comments from time to time. I have covered it in my previous columns that I believe US administration will opt for a weaker US Dollar. It can come due to trade war between US and world and also direct intervention in the currency. However, there will be instances in the world financial markets, when sudden explosion in risk aversion would trigger a broad based US Dollar run against almost all currencies but we would expect Rupee to not only outperform its peers in such an event but also retrace its losses against USD, once the phase of risk aversion ends.
A major threat to Rupee remains, higher commodity prices, which can not only be inflationary but also exert an upward pressure on our current account deficit. However, I believe industrial commodities are in a primary bear market and the ongoing ascent is more like a counter trend rise. Above chart depicts how important Chinese credit impulse remains for industrial commodity prices. As the credit impulse and hence Chinese growth impulse fades, we can expect, the upswing in commodity cycle to end.
Before I conclude, let me touch upon a medium term factor which is tying the hands of RBI in the foreign exchange market. It is the high Rupee liquidity. Post demonetisation, banking system is caught with excess 3-5 lakh crore of excess Rupee liquidity. According to Bloomberg data, lower cash in circulation and previous intervention in spot market to purchase US Dollar and sell Rupees have augmented Rupee liquidity to nearly 5 lakh crore. As a result, RBI is being forced to buy US Dollar to support the value of USDINR through the derivatives market called forwards market. However, unlike spot intervention, derivative intervention lacks the same impact. At a time, when global hedge funds are piling on the Indian Rupee to play carry trade, forward intervention may not be enough. A low downside volatility in Rupee is fuelling further carry trades in it.
Discussions on markets are never complete without the dessert of technical analysis. So here it is for the Rupee. USDINR has broken down from a long range. After its double top in 2016, market players took another year to make up their mind on the pair. In that years’ time, the pair made a third attempt at moving past 69, but failed. Now the range has resolved to downside. Path of least resistance appears to be downward. However, USD bears need to contain the counter trend bounces below 66.20/30 region on spot.