Why Has the Indian Rupee Been So Weak?

Summary

• INR performance has lagged other Asian currencies over recent months after the strong rally in August.
• A more pro-growth RBI and stepped-up intervention explains the currency weakness, rather than any big shift in fundamentals.

Market Implications

• Medium term – Neutral FX. Rupee looks set to remain stuck within 73-75/USD, but yield pickup will remain favourable.

We’ve been bullish on INR over the past few months. Above-target inflation, an improved BoP position and a healthy yield differential all supported a stronger rupee, and INR was among Asia’s best performing currencies in Q3. But since early October the currency has traded consistently weaker, with USD/INR up from 73 to almost 75 in early November. As this fall is at odds with a strong performance across the rest of the region, we review whether fundamentals, or policy preference, has shifted.

1) RBI Now Has Greater Comfort on Inflation

September’s 7.3% YoY reading on inflation is an eight-month high and marks six months where CPI has been above the upper bound on the RBI’s 4-6% target. Higher food prices are largely to blame, with the 9.7% reading contributing 4.5pp to headline CPI. Increased fuel taxes have added further. Yet the RBI (with its three new external members) have turned more sanguine on inflation.

Minutes from the 7-9 October meeting point to the expected disinflation within the household expectations survey. And indeed, one-year ahead expectations have stabilized and are now below those for three-months, albeit at elevated levels. India’s ongoing rollback in COVID restrictions should, according to the RBI, see cost-push pressures ease and, combined with a drop back in some food prices, guide inflation lower.

The central bank’s forecasts are for inflation to drop to 6.8% for Q2 FY20-21 (Q4 calendar 2020) and to ease further through the coming quarters. Contrasting other EM central banks that describe risks to inflation as uncertain, the RBI see risks to their forecasts as ‘broadly balanced’. Moreover, they explicitly say that recent CPI acceleration can be ‘looked through’.

2) Priority Pivots Towards Reviving Growth

That reviving economic growth will be the ‘highest priority’ of the RBI leaves further rate cuts as only a matter of time (the RBI cut rates by 115bps between March and May but has been on hold since then). Aside from a few European countries, India is expected to see one of the deepest economic contractions globally this year, with IMF GDP projections at -10.3%. Mexico is next in line with a projected -9.0% contraction this year.

What is striking about Mexico and India is the paltry fiscal response. While Mexico’s reflects an overzealous commitment to fiscal austerity, India’s is more a budgetary constraint. A higher starting point on debt and collapsing revenues left a sizeable expansion in financing needs even before any stimulus was enacted. India’s two fiscal packages amounted to just 1.2% of GDP, according to Moody’s, but that still leaves a fiscal deficit of 12% of GDP.

Ongoing constraints over fiscal support leave the RBI using all its tools to ease financial/monetary conditions. A variety of liquidity measures have been introduced, and the RBI’s liquidity surplus is significantly increased. But a competitive exchange rate which supports the export sector will also help as world trade recovers. India’s REER has strengthened around 4% since March, despite RBI intervention, and is around 7% stronger than two years ago.

3) Trade Improvement Remains Intact

India has not enjoyed the same export rebound as Asia’s tech exporters. But with the largest share of oil imports in Asia (at just above one quarter of total imports), the once-large trade deficit has narrowed on a lower oil bill. As such, India’s import growth stands at -19.6% YoY in September versus a positive average across China, South Korea, Taiwan and Singapore. And at just $2.7bn in September, the trade deficit has shrunk by nearly half on a 12-month rolling basis. Monthly data show the services surplus stable at $20bn each quarter, leaving the headline C/A much improved. Q3 C/A data are due at the end of the year and should remain in surplus after the record high in Q2 (0.4% of GDP four-quarter rolling).

Capital inflows have also been a significant driver of rupee performance in recent months. Sizeable investments into the tech sector saw 1m rolling equity inflows peak at $6bn in August, and with it, USD/INR moved lower. The pace of inflows dropped back in September but has recovered more recently. A stronger currency has not, however, accompanied these renewed inflows.

The rupee’s high yielder status is also attractive. RBI liquidity injections have pushed 10yr rates below 6%, but the pickup over 10yr US Treasuries is still around 500bps. And with rate cuts unlikely before next year, this is unlikely to change much in the coming months.

4) RBI Intervention Looks to Have Gathered Pace

Latest RBI intervention data are through August and show $5.3bn in net FX purchases, after almost $16bn in July. More recent weekly reserves data suggests stepped-up intervention. From $500bn as of 25 September, RBI FX reserves have jumped to $517bn as of 23 October.

We expect this intervention to continue. The RBI said in August that a stronger rupee helped curb inflation. But with price pressure no longer such a concern, we think this view has shifted. And while we do not expect the RBI to act to materially weaken the currency, INR is likely to lag a broader EM rally with a move back below 73 now unlikely.