The rupee (INR) has weakened sharply against the dollar (USD); since the lows of below-63.50 to the dollar in January, it is now hovering at around 66.80, a drop of almost 5%. While we had long expected a depreciation of the INR, the pace and extent of the move has been unexpected, and the underlying dynamics need to be better understood. There are three broad dynamics which will play a role in the INR’s future path:
- The direction of the USD agai nst other Developed Market (DM) currencies;
- “Carry” driven portfolio flows into Emerging Markets (EM), including India; and,
- India’s own economic environment, particularly its balance of payments (BoP).
The accompanying graphic shows the movement of the INR since mid-February. While the slide started with the revelation of a problem at a bank, it was short-lived, and the currency re-converged with the broader EMFX complex in a few days’ time and remained stable till about mid-April. The sharp move over the past few days was much more in line with the EMFX; only, this time, this was reinforced by the strength of the USD against the DM currencies.
The proximate cause for this sharp depreciation was the rise in prices of industrial metals and oil, sanctions against Russian companies contributing to the former, and higher demand and falling inventories adding to price pressures. Of course, other political and trade developments have contributed to the rising volatility. The re-emergence of differentials, between the continuing robustness in the US economy and a moderation in momentum in Europe, is likely to lead to continuing USD strength.
The second set of factors then come into play. There has been a significant outflow of portfolio debt investments ($2.6 billion since February) from India and a milder outflow of equity ($ 0.6 billion). This was in line with an overall reduction in “carry” driven portfolio flows to EMs, but India has largely under-performed on these flows in the past few months.
The other potential driver of EM currencies, particularly in Asia, is the strategy for managing the Chinese Renminbi (CNY), which has remained very stable of late. The USD/CNY spot had depreciated sharply in August 2015—after the Chinese authorities had subjected the CNY to a mini-devaluation, but had thereafter shifted guidance from the USD/CNY pair to a broader basket of currencies, the CFETS. While the CFETS had been broadly reversed since mid-2017 to an appreciating mode, and there are signs of a prospective resolution to a potentially disruptive trade war, a gradual depreciation as part of a strategy on trade is a possibility.
As for economic fundamentals, while most EM currencies have depreciated in this latest round, foreign exchange (FX) markets appear to be differentiating against energy- and commodities-importing countries for the past few months (of course, there were other factors). The currencies have broadly moved in two broad groups—the depreciating ones being countries with Current Account Deficits (CAD).
India’s key economic metrics now, compared to the “taper tantrum” days of June 2013, are unquestionably more robust. But one metric, related to short-term (ST) debt, stands out—$96 billion of this $217-billion ST (by residual maturity) debt is trade credit. While the extent of the debt is not particularly of concern, given the concomitant economic growth, the share of this debt to exports (which is the core repayment coverage metric) has risen over this period.
In addition, India’s FX reserves are adequate, according to IMF’s assessment, although the metric also showed adequacy during the turbulence of FY14, albeit with a much narrower margin. By this metric, India is comfortably placed with reserves at $430 billion, well in excess of the $275 billion the framework advises. However, to be safe, the framework recommends reserves at 150% of the metric number, and the present buffer is likely erode over FY19 and FY20.
It is in this context that understanding the evolving Balance of Payments (BoP) in India becomes so important. At present, we expect the FY19 CAD at 2.5% of GDP ($73 billion), but the risks are of a higher deficit if oil stays at high levels for extended periods. We expect net capital inflows of around $83 billion (with a risk of lower flows), but this is contingent on the pattern of FX intervention by RBI.
While a certain degree of volatility is desirable in FX markets, RBI’s intervention will be designed to prevent any undue or large movements. The choice of intervention in spot and forward FX segments will be determined by prevailing rates and domestic liquidity. Note that the forecast of $83 billion net capital inflows in FY19 factors in the maturing of an estimated $16 billion of outstanding forwards (adding another $5 billion of interest earnings on offshore assets), which might turn out to be quite different depending on the evolving economic environment.
In addition, management of restrictions on various capital flow channels and instruments, as with debt portfolio and commercial borrowings recently, offers yet another set of levers to calibrate capital inflows.
To sum up, while the moderate uncertainties regarding India’s external balance of payments have begun to be priced into the rupee, India’s economic fundamentals remain strong and policy authorities have sufficient buffers to ensure that volatility in the external account remain contained.
The author is Senior vice-president Business and economic research, Axis Bank Views are personal.
With contributions from Tanay Dalal