Over the past year, the rupee has already strengthened by around 4% against the dollar, while most emerging market currencies have been broadly steady or somewhat weaker
Trying to pinpoint turning points in markets is the ultimate foolishness, but on a long holiday weekend with constraints on stepping out increasing, and after a few cocktails, the mind does turn to foolhardy things, and one that it settled on today was the question above: How much longer can the rupee stay strong? While over the past few months, the rupee has been jammed in narrow ranges (first 73 to 74.50 between September and December last year, and then 72.50 to 73.50 during the first calendar quarter of this year), the apparent “stability” is misleading. Most importantly, spot volatility, while still low, has just climbed above its 100-day average—the last time that happened was at the end of March 2020, at the start of the pandemic and the rupee’s last collapse.
To be sure, this could—partly at least—be related to liquidity issues having to do with the financial year-end. Indeed, the near-term premiums surged above 10% pa both in late March 2020 and 2021. However, the difference is that, in 2020, RBI was intervening to prevent the rupee from weakening sharply, desperately buying spot dollars since infusing liquidity was the need of the hour. Today, with inflows strong, RBI needs to prevent rupee appreciation, but simply buying incoming dollars at spot doesn’t do the trick since market liquidity is already excessive and inflation is threatening with oil prices much higher; thus, for the past couple of months, RBI has been intervening buying the forwards. This device, too, appears to be reaching its limits, with premiums soaring and RBI reportedly having accumulated about $50 bn in the forwards.
And then, of course, there is the NDF market, which has been enjoying/driving the uncertainty. The spread at 1 month is running at around 10 paise every day for the past month or so, which makes it clear that, despite strong inflows, there is continuing speculation against the rupee. The accompanying chart shows that the rupee, which slipped suddenly early last week, bounced back strongly from a medium-term technical support line that started when the rupee fell sharply to near-77 at the start of the pandemic.
While it still has to cross a more recent (but still reasonably long) resistance, it does appear that the long term uptrend remains intact, driven as it is by huge global liquidity and reasonably firm domestic interest rates. Again, RBI has just recently reconfirmed its inflation target range as 4% with a 2% band on either side, which suggests that if inflation continues strong—and there are now many global analysts who are calling for just that—RBI may be compelled to raise interest rates before too long. While this would be negative for equities, it may, depending on global sentiment, strengthen the legs under the uptrend.
Over the past year, the rupee has already strengthened by around 4% against the dollar, while most emerging market currencies have been broadly steady or somewhat weaker. And, in any case, the trend is getting somewhat old in the tooth—it has already run for 338 days, which is just short of the average period of rupee strength since 2014 (354 days). Given the delicate nature of the equilibrium, any new destabilising forces—a poor BJP showing in the West Bengal election, for instance, or a sharper Covid surge in Mumbai and other cities opening the prospects of another lockdown, or, of course, some unknown unknown—could puncture the rally.
As the accompanying graphic shows, the rupee doesn’t have to fall too much below 74 to open up 75 and worse. With the premiums having come back to close to normal, importers should increase their hedges. If spot volatility continues to rise and the NDF spread stays in double digits, exporters could hold back on further immediate hedges.