It has nearly been a month since the historic BJP electoral sweep. We have seen equities climb to record highs on expectations that the Modi government led reforms will finally unlock India’s true economic potential. Mid-cap and small-cap stocks have outperformed blue chips in recent weeks indicating that the risk appetite is returning to the Indian markets. Gold has witnessed a correction and FII has flowed into the debt markets with the ten year yield having fallen 50 basis points since April. However, one asset class has not been privy to this recent upsurge in optimism – the rupee has been trading in a narrow range and has started weakening against the dollar, eying the all important (and sentimental) 60 mark.
Currency Corner had argued back in April that the rupee upside would remain capped at around 57-58 to the dollar. There are two key reasons why the rupee appreciation has been limited. Firstly, it may be the case that the short USD-INR trade has been too over crowded. There has been ongoing compression in the shorter-dated USD-INR Non Deliverable Forward (NDF) curve, which now offers an implied yield of around 5 percent annualized in the one-month tenor. This is down from nearly 10 percent in April according to HSBC.
Secondly, the Reserve Bank of India has seen strong inflows to build up its FX reserves. According to the weekly data released by the RBI, headline FX reserves have risen by $17 billion since the end of last year, with a rise of $5.7 billion between April 25 and May 16 alone. The RBI’s attempt to build up FX reserves is of course a long term positive for the rupee, but in the short run, this is likely to limit its upside against the greenback.
Another reason to remain slightly biased towards rupee depreciation in the short run is that the current account deficit is all set to widen again. According to HSBC, the narrowing of the current account deficit to 0.2 percemt of the GDP in the first quarter of 2014 from as large as 6.5 percent in the fourth quarter of 2012 is unsustainable. HSBC estimates that nearly half of that decline stemmed from a sharp drop in gold imports. The other half was due to a temporary boost to exports from a cheapened currency last year and compressed imports owing to weak domestic demand. As restrictions on gold imports are gradually lifted (and this is inevitable), the current account deficit will widen again. A doubling of gold imports from the current depressed levels of 25 tonnes per month would widen the gold deficit by about $1 billion per month (0.2 percent of GDP, assuming stable gold prices) according to HSBC. This would still be well below the pre-restriction trend of gold imports of about 80 tonnes per month.
Lastly and most importantly, one has to factor in the behavior of US yields. RBI governor Raghuram Rajan has gone on record to say that the effect on emerging market countries should be kept in mind by the Federal Reserve as they “normalize” their easy monetary policies. As the Fed continues its QE taper, the dollar and US 10-year yields will be on a steady upward trajectory for the rest of 2014. Further, the ECB and the Bank of Japan are all set to unleash unconventional monetary policy measures to combat deflation as this column has argued in recent weeks. This again implies across the board dollar strength. When this scenario plays out, the rupee can outperform its emerging market peers but only in terms of relative depreciation.
As things stand, the rupee should trade in a narrow range. Further appreciation beyond 57-58 to the dollar is unlikely due to the factors mentioned above. At the same time, there is no reason to be aggressively bearish on the currency in the prevailing bullish sentiment towards India by foreign investors.