Rupee – The Way Ahead Nishu Agarwal (nishu.agarwal@bmastock.com) 25 April, 2012

Rupee – The Way Ahead

More downside expected: India’s rupee has been the worst performing currency in Asia, excluding Japanese yen since August 2011. It declined by nearly 22% from August 2011 to December 2011. Although the currency stabilized somewhat in February 2012 after the intervention from Reserve Bank of India, the pain seems far from over. Given the macro-economic situation, both domestically and globally, we might see further depreciation in rupee and we might have to adjust ourselves with lower levels of currency in times to come.

Weak domestic economic framework: Among the Asian currencies, rupee was one of the worst affected largely owing to India's high current account deficit, while most other Asian countries have a current account surplus. The redemption pressure on account of rising short-term external debt also exposes India's external vulnerability in the wake of weak global capital markets. The domestic factors that further pressurized the rupee include slowing growth, a high fiscal deficit, continuous high inflation and lack of policy reforms

Fragile global economic framework: The global economic situation has worsened following escalating crisis in the Euro zone and the US sovereign debt downgrade. Under these circumstances of rising risk aversion, the emerging economies are bearing the brunt due to the flight of capital towards the USD

Limited tools in the hands of RBI: In order to curtail the weakness in the rupee, the Reserve Bank of India had taken some initiatives. However, the measures are expected to be short-lived and due to inherent weakness in the Indian economy, the depreciation in the currency might continue. The RBI might continue to intervene in the currency markets to curb the volatility in rupee, but ultimately it will be left with limited tools to maneuver

Asian currency performance vs USD

Source: Bloomberg

2012 Real GDP YOY% (April 2012)

2012 Real GDP YOY% (September 2011)

China 8.2 8.2*

India 6.9 7*

South Korea 3.5 4.4

Indonesia 6.1 6.3

Taiwan 3.6 5

Thailand 5.5 4.8

Malaysia 4.4 5.1

Hong Kong 2.6 4.3

Singapore 2.7 4.3

Philippines 4.2 4.9

IMF’s economic growth forecast across Asia

Source: Bloomberg *Forecasts were updated in January 2012

Domestic Economic Framework

Balance of Payment financed by volatile capital inflows: There are two key issues plaguing India’s balance of payments (BoP): one, the size of current account deficit is unsustainably large; and two, the majority of financing of the deficit is via volatile capital inflows that can reverse quickly. During Q3 of 2011-12, India’s BoP experienced a significant stress as trade deficit widened and capital inflows fell far short of financing requirement resulting in significant drawdown of foreign exchange reserves. It slipped into the negative territory for the first time in three years. It had last been in the red in the December quarter of 2008, soon after the Lehman crisis. The current account deficit (CAD) widened to US$ 19.6 billion in the same period which works out to be 4.3% of GDP, up from 4.1% in the previous quarter.

Thus, India is vulnerable to the risk of inadequate financing of the deficit and to uncertainty regarding the sustainability of financing.

Widening Current Account Deficit (CAD): The CAD measures the country’s external deficit which it needs to cover through borrowings or inward capital flows or investments. India’s CAD is approaching 4% of GDP which is the second highest since March 2002. To check the widening CAD, government allowed freer borrowing from foreign lenders by raising the investment caps in external commercial borrowings and foreign investment in government and corporate debt. Dependence on foreign borrowings to finance the CAD is difficult as repayment becomes harder in the event of a big depreciation.

Rising Short Term External Debt (USD, billions)

Source: Bloomberg

Widening Current Account Deficit (% of GDP)

Source: Bloomberg

Domestic Economic Framework

High oil prices to take a toll on trade deficit: The CAD might suffer further due to rising trade deficit. India imports nearly 80% of its crude oil needs, leaving it vulnerable to gains in crude oil prices. Crude oil prices have gained nearly 30% since October 2011, and continues to gain further on the back of concerns related to sanctions against Iran by the US and the EU. This will not only raise concerns over India’s current account deficit, but at the same could potentially delay monetary easing, thereby coming in the way of an expected improvement in the domestic growth-inflation balance. Thus, INR’s regional underperformance is likely to continue if oil price remains elevated.

Lack of policy reforms to deter FDI flows in India: One solution to check the widening current account deficit is to encourage non-debt long-term capital flows in India i.e. to attract foreign direct investment (FDI) to India. However, policy paralysis in government is deterring such flows. There is certainly a large backlog of legislation including bills to modernize indirect taxation, to boost investment in mining and to facilitate land acquisition. Executive decisions are also needed to liberalize foreign direct investment (FDI) in the retail and aviation sectors. Meanwhile, liberalization of the labour market, which is perhaps the single most important reform, has long been discussed but is considered politically too difficult to tackle.

In 2010-11, at a time when flows to the rest of the emerging market economies (EMEs) were heading north, inflows into India were below par.

Source: Bloomberg

Rising Crude Oil Prices(USD, per barrel)

Dwindling Monthly FDI (USD, millions)

Source: Bloomberg

Global Economic Framework

Muted global growth: According to the IMF (World Economic Outlook – Jan 2012), the world GDP growth is expected to decelerate to 3.3% in 2012 from 3.8% in 2011 with recession in the Eurozone and extremely anemic growth in the UK. This could potentially reduce the appeal for risky assets like INR.

European Union sovereign debt crisis: Despite continuous efforts, the European debt crisis which started in late 2009 seems far from over. Although Greece has managed to win its second bailout package with assistance from the Troika and private sector involvement to tide over its immediate redemption pressure in Mar-12, the country still remains vulnerable as economy has been suffering from recession for the last 3-years and more importantly is expected to remain in one for the next 2-years. Lack of growth will make fiscal austerity extremely challenging amid an unstable political environment. While sovereign debt has risen substantially in only a few eurozone countries, it has become a perceived problem for the area as a whole.

Rising risk aversion leading to the flight of capital towards USD: Due to deteriorating global growth and escalating EU debt crisis, risk aversion has increased. As a result, the emerging markets are bearing the brunt due to the flight of capital towards the USD.

Source: Bloomberg

Gain in USD due to risk aversion

IMF Projection for GDP Growth (% pa)

2011 2012

World 3.8 3.3

Advanced Economies 1.6 1.2

US 1.8 1.8

Euro Area 1.6 -0.5

UK 0.9 0.6

Emerging & Developing Economies 6.2 5.4 Source: Bloomberg

Limited Tools With RBI

Large intervention ruled out: The size of currency market today is huge: ~30bn USD a day of onshore and ~40bn USD of offshore trading on a daily basis. If the central bank decides in favour of an effective intervention, it will need to place orders worth 4-5bn USD daily. With the present reserves at 270bn USD, it would last for close to 2-2.5 months. The speculators might latch onto the opportunity to short it in the event of depleting reserves and try to achieve the fair value. If the RBI intervened to protect or create a floor, everybody would try to shift monies out of the country at the virtual price created by the RBI, only to return when the RBI has given up on intervention and rupee returns to its correct valuations, thereby earning the price differential. Ultimately, this leads to a sharp and quick depreciation than would have happened without intervention. The central bank is left with lower reserves and similar or worst currency pressures.

Balance between Inflation and Growth: RBI recently cut the interest rates by 50 basis points. It justified the rate cut on grounds of slowing growth as exhibited by disappointing industrial production data (4.1% yoy in February and 1.1% in January). It, however, acknowledged persistent upside risks to inflation. Much of the recent decline in WPI has been due to temporary factors - base effects and a seasonal drop in food prices, especially vegetables. Food-price inflation is already picking up again. Belying the moderation in headline WPI, March wholesale prices of primary food articles rose 9.94% yoy compared with 6.07% in February. The fuel inflation is also set to increase due to gain in crude oil prices. Together, food and fuel items have a large 46.5% weighting in the calculation of India’s WPI. Thus, if the inflation persists, the real interest rate would continue to remain in the negative territory in the Indian economy, further leading to lower levels of currency.

Thus, despite being at lower levels, INR might decline further, to reach close to 55-56 levels in the short term.

Source: Bloomberg

RBI Net Purchase of US Dollars (USD Million)

Components of India’s Wholesale Price Index

Source: Bloomberg

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