Asia | Emerging Markets | FX | Monetary Policy & Inflation
USD/INR has struggled to break below 74.50 over the past month even as the dollar (DXY) has weakened. This reflects a broader dynamic in FX markets, where dollar weakness is less pronounced in EM markets. Indeed, other similarly yielding EM currencies, such as the South African rand (ZAR) and Mexican peso (MXN), have recently suffered from notable bouts of weakness (Chart 1). Moreover, INR seasonality shows that August tends to see rupee weakness, with EM FX generally faring poorly during the month – the 2015 CNY devaluation and 2018 TRY sell-off are examples of volatile events occurring in August (Chart 2). INR/USD futures could therefore see a return to the 132 level or lower in coming weeks.
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USD/INR has struggled to break below 74.50 over the past month even as the dollar (DXY) has weakened. This reflects a broader dynamic in FX markets, where dollar weakness is less pronounced in EM markets. Indeed, other similarly yielding EM currencies, such as the South African rand (ZAR) and Mexican peso (MXN), have recently suffered from notable bouts of weakness (Chart 1). Moreover, INR seasonality shows that August tends to see rupee weakness, with EM FX generally faring poorly during the month – the 2015 CNY devaluation and 2018 TRY sell-off are examples of volatile events occurring in August (Chart 2). INR/USD futures could therefore see a return to the 132 level or lower in coming weeks.
In terms of drivers of this move, with now more than 1.5mn COVID cases in India and the daily case count passing 50,000 for the first time last week, economic activity is normalising only slowly. Two months of improvement in the manufacturing PMI came to a halt in July, with declining output and new orders pulling the headline index down from a month earlier and further into contractionary territory.
The scale of the country’s recession, with Q2 GDP projected around -20% YoY, is such that the RBI is set to ease policy further in the coming months following Thursday’s pause, even with inflation above the RBI target. This would take real rates deeper into negative territory, which would weigh on INR.
So far, INR performance has held up with significant foreign inflows into the stock market and a sharp turnaround in the current account. But with oil prices up around 50% from the April lows and India’s exceptionally weak import growth in recent months reflecting the very strict lockdown, the scale of the current account improvement looks unsustainable. And, with valuations looking stretched on the stock market, foreign equity inflows could also start to drop back.
Financial sector stress could also start to weigh on the rupee. The RBI’s recent financial stability report projects nonperforming assets to jump to 12.5% (from the current 8.5%) in its base case scenario of -4.4% GDP growth this year, or close to 15% in a worst case scenario. This brings to an end the improvement seen over the past year and, according to S&P, will leave India with the highest NPLs among major economies (Chart 3). A loan moratorium due to end this month could well be the crunch point for banks, and bad loans then start to accelerate.
Therefore, while in earlier reports we favoured INR as a carry trade, we now view the currency as likely to weaken over August.
Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)