Asia | COVID | Economics & Growth | Emerging Markets | FX
– New highs in India’s basic balance should support further INR strength
– Currency strength remains at odds with a very weak macro outlook
– COVID cases have exceeded 3.7mn leaving further downside risks to the recovery
INR’s usual seasonal pattern of August weakness came to a halt this year. Appreciation of almost 2% through the month left the rupee as the region’s best-performing currency and saw the currency trade sub 74/USD for the first time since March. The sizeable FX intervention over recent months – FX reserves are up almost $50bn through the first six months of the year – looks to have come to an end and leaves questions over a change of exchange rate strategy from the RBI. Given this policy shift, we no longer expect INR weakness and see scope for further modest appreciation.
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- New highs in India’s basic balance should support further INR strength
- Currency strength remains at odds with a very weak macro outlook
- COVID cases have exceeded 3.7mn leaving further downside risks to the recovery
INR’s usual seasonal pattern of August weakness came to a halt this year. Appreciation of almost 2% through the month left the rupee as the region’s best-performing currency and saw the currency trade sub 74/USD for the first time since March. The sizeable FX intervention over recent months – FX reserves are up almost $50bn through the first six months of the year – looks to have come to an end and leaves questions over a change of exchange rate strategy from the RBI. Given this policy shift, we no longer expect INR weakness and see scope for further modest appreciation.
Second quarter BoP data will be released in the coming weeks, and we expect to see India’s basic balance (C/A + FDI + portfolio flows) approach new highs. Merchandise trade data show the goods deficit narrowing from around $35bn in Q1 to just $9bn in Q2, with oil imports down by $20bn or 60% QoQ. And with services exports holding up (monthly data put the Q2 services surplus largely unchanged from Q1 at $21bn), the headline C/A is likely to have remained in surplus. But the bigger driver is FDI, and to a lesser extent portfolio inflows. As we have discussed in earlier notes, India has seen sizeable inflows, much of which has been directed towards Reliance Industries / Jio Platforms. Over the past two months, foreign equity inflows have reached a very significant $7bn, outpacing the $4bn in Q2 and a Q1 outflow. This points to second quarter basic balance climbing above the $20bn in the first three months of the year (just under 1% of GDP) and then towards the 2016 highs of around $30bn in H2.
New highs in India’s basic balance and an RBI abandoning its earlier prudent stance of mopping up inflows, perhaps due to concerns over the extent of balance sheet expansion plus inflation above target at 6.9% YoY, point to scope for further rupee appreciation. Carry also remains attractive with the RBI on hold at 4% last month, leaving nominal rates among the highest in EM.
Rupee Performance Masks India’s Significant Economic Weakness
Recent currency strength is at odds with the country’s very weak macro outlook. COVID continues to spread rapidly with now more than 3.7mn cases in India and the country recording the world’s highest daily case increases (>70,000) in recent weeks. Concerns over the virus will impact mobility and delay the recovery even with lockdown restrictions being eased further.
GDP growth for the April-June quarter was already the worst in the region at -23.9% YoY (consensus at -18.0%). According to the IMF it was also the deepest contraction in the G20 on a QoQ non-annualised basis. While Q2 is expected to be the low for activity given the partial recovery in India’s PMIs, exports, and IP, the combination of a continued run-up in COVID and the absence of any new policy support leaves the economy firmly on track to record one of the deepest contractions in Asia this year.
Rising inflation and fiscal constraints are not helping. Just four months into India’s fiscal year, the deficit exceeded the INR7.96tn target (3.5% of GDP) with revenues slumping. The IMF’s April Fiscal Monitor already saw the deficit at 7.4%, and, given the downward growth revisions since then, this could yet be worse. RBI bond buying could help budget financing but would raise further concern over the bank’s independence. Former deputy governor, Viral Acharya, warned recently that any monetizing of the deficit would risk both inflation and external stability and at this point seems unlikely. Instead, the RBI looks set to continue its efforts to push down long end yields with further twist operations.
We exit our previously bearish view and now see INR benefiting from its high-yielding status and significant basic balance improvement.
Caroline Grady is a Senior Researcher at Macro Hive. Formerly, she was a Senior EM Economist at Deutsche Bank and a Leader Writer at the Financial Times.
(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.)