INR – Asia’s Worst-Performing Currency in 2020

Summary

• Rupee looks set to end the year as Asia’s worst-performing currency
• This reflects RBI FX intervention with FX reserves up $xbn YTD
• Further improvement in the trade deficit needs a structural shift in policies, not a cheaper INR
• With above-target inflation and a rising cost of intervention we expect the RBI to step back

Market Implications

• Medium term, positive FX: With further intervention contained we expected USDINR to head lower

Inward-looking policies Are Preventing An Expansion in India’s Export Base

Like China, improvements in India’s trade and current account are a key driver of recent FX dynamics. But while China has allowed its currency to appreciate, the RBI is wary that capital inflows rather than trade dominate, and they continue to actively intervene. USD/INR is broadly flat so far in Q4, while CNH has strengthened by almost 4%. YTD the divergence is even more striking, with CNH stronger by more than 6% versus a depreciation of around 3% for the rupee. This leaves INR on track to become Asia’s worst-performing currency this year.

The turnaround in India’s C/A (and broad basic balance) has been remarkable this year. Given the initial collapse in imports, we were sceptical about how long the turnaround in trade dynamics could be maintained. With the recovery now underway, it seems at least part of this improvement will last. But is a more competitive rupee the near-term answer to improved export growth? We don’t think so. India’s share of global exports has been stuck around very low levels for years, domestic policies are increasingly inward-looking and trade restrictions are rising. A structural pivot back towards export-orientated growth is needed for a medium-term turnaround in exports.

Alongside a reduced trade deficit with oil exporters, one notable aspect of India’s trade improvement is the reduction in its deficit with China. The deficit stands at $38bn through October (12m rolling basis) versus $52bn a year earlier (Chart 1). This reflects increasing tensions between the two countries, which have resulted in imports being held up, a ‘digital strike’ against China with countless Chinese apps banned in India, and reduced investment between the two countries.

Limiting FX appreciation will therefore make no material difference to the outlook for the oil balance, or the deficit with China. At the same time, limiting rupee appreciation prevents any reduction in import costs.

RBI Balance Sheet Expansion Will Eat Into Profitability

India’s stubbornly high inflation (7.6% YoY) has prevented the RBI cutting rates further, with the policy rate stuck at 4% since May. At the last policy meeting in early December, Governor Das reiterated the commitment to reviving growth and ensuring inflation returns towards target. But the tone was slightly less dovish than before. The RBI continue to see above-target inflation driven by supply disruption and indirect tax hikes, but the earlier reference to looking through high inflation was omitted.

In the current environment of significant EM inflows on expectations of a global rebound, India’s equity market could well continue to benefit. November inflows remained close to all-time highs at $8bn and have remained strong so far this month. Bonds will also remain attractive, with 10-year yields staying around 500bps above the US. Coupled with the improved trade dynamics, we expect the underlying dynamics for rupee appreciation to continue.

Comfort over balance sheet expansion will ultimately drive RBI intervention. At around 29% of GDP this is small versus major central banks, but it is up by more than 10pp in two years to almost $750bn (Chart 2). And one important difference with major DM central banks is the level of interest rates. RBI profitability will take a hit from the interest cost on rising liabilities, while interest earned on FX assets will be minimal.

As central bank profits are partly transferred to the budget, the cost of FX intervention can become political. The combination of rising costs from FX intervention, lack of material support to growth from capping rupee gains, and above-target inflation all suggest further intervention will be reasonably contained.

We see USD/INR heading lower in the coming months, but even with a rangebound rupee performance, the currency will remain attractive as a carry play.