Last May, after the US Federal Reserve first announced a likely roadmap for Quantitative Easing (QE) taper, Morgan Stanley labelled India as a “fragile five” club member with other emerging economies like Turkey, South Africa, Brazil and Indonesia. Emerging markets were bound to be hit with the withdrawal of cheap liquidity from the system. A rush of money back to the developed markets (which meant a stronger greenback), coupled with domestic fundamental challenges such as dwindling foreign exchange reserves and high inflation, pushed the rupee to an all time low of 68.8 against the dollar in the next couple of months.
Historically, March has always been a good month for the rupee and together with the overall market optimism of a Narendra Modi-led stable coalition government at the centre, the rupee is displaying a close correlation with the Nifty once again. To be fair, credit must also be given to the UPA government as India’s macro outlook has improved considerably over the last year as a result of the fiscal-tightening measures. Well before the equity rally gathered steam, the rupee outperformed the MSCI emerging market currency basket in January during the EM currency turmoil.
With the Indian rupee close to the key psychological 60 level against the dollar, one would expect the RBI to be rebuilding reserves. According to the Bank of America, the central bank has bought $5 billion (including maturity of FX swaps with oil companies) since mid-March. India’s import cover, at 7.5-8 months, is well below the 10 months needed for INR stability which would justify further accumulation of reserves.
At this juncture, Indian equities have room for much further upside from current levels. But the same cannot be said about the rupee. In 2009, the INR did jump three percent on the 2009 poll result. (Equities gained 18 percent in two days post the result.) However, here are two key differences. In 2009, the INR had lagged recovery in EM currencies after the Lehman collapse as the FX market feared the event risk of the May 2009 elections. In contrast, in 2014, the INR is outperforming the Fragile Five peers. Further, in 2009, the RBI allowed the INR to appreciate as import cover was high. In contrast, again, inadequate import cover will now force the RBI to buy FX if the emergence of a stable government attracts capital inflows according to a Bank of America report.
More importantly, even on the back of the US Fed taper, the dollar index is still trading below close to the 80.5 level. Going forward, the European Central Bank and the Bank of Japan are widely anticipated to add monetary stimulus as has been written in this column in previous weeks. The yen and the euro are poised to weaken against the dollar. We can see the euro at 1.3 and the USD/JPY pair at 110 by year end. The dollar index can rally to levels close to 85-87. It is hard to see the rupee appreciating further beyond 57-58 levels over the next year. Further, RBI Governor Raghuram Rajan has cited a finance ministry report to suggest that at any level below 57-58 to a dollar, he would consider the rupee to be overvalued.
A “market friendly” result on May 16 can take the rupee to 57 against the dollar. But at that point, one would have to be very brave to bet on further appreciation.