Rupee: Three billboards of worry
The Indian rupee hasn’t had a good run in the last two months. The economy it reflects is still finding its lost animal spirits as investment demand continues to be tepid. The financial system the currency represents has had a big blow to its credibility as fraud after fraud has been uncovered in its public sector banks.
The reasons are clear.
India’s current account deficit is set to widen sharply for fiscal year 2018 (FY18) and could very well do so in FY19 too. The latest trade data leaves no doubt as the deficit is already near $80 billion for the first nine months of the current fiscal year. Imports have surged as global oil prices have been climbing while exports haven’t really turned around. Most economists are predicting current account deficit to widen to 1.7% of gross domestic product (GDP) from 1.1% of GDP in 2016-17.
Domestic retail inflation is rising and basic economics calls for a weakening of the Indian currency.
The real effective exchange rate that captures the competitiveness of the rupee against 36 currencies showed that the Indian unit should have been 22% weaker than it was in January.
The Reserve Bank of India (RBI) would be hard-pressed to keep policy rates untouched in the wake of rising inflation. That means rising borrowing costs for corporates and consequent erosion in earnings. Hence, the rupee should weaken to reflect a modest economic growth.
But perhaps the biggest threat to the Indian currency is the dollar. The US Federal Reserve’s new chairman Jerome Powell’s comments have sparked expectations of at least four interest rate hikes by the Fed in 2018. That means dollar assets would begin to give higher returns, thereby dimming the appeal of emerging market assets.
A Bloomberg article states that the sharp fall of the Indonesian rupiah to a two-year low is a sign that emerging market currencies will soon see an end to their rise. However, the dollar index has been trending lower and has slipped 2.6% since January.
The rupee has already weakened 1.8% so far in 2018 to hit 65 to a dollar. But this has been partly orchestrated by RBI as it bought $7.3 billion from the market in January, the largest in a single month in three years.
The onshore as well as the offshore forward markets are predicting a further fall to around 65.80 to a dollar by June.
But ironically, forecasters have raised the rupee’s value in the short term. For instance, the median forecast for the rupee in Bloomberg’s survey of 50 respondents was 65 in December, which has now risen to 64.25 to a dollar. Essentially, forecasters now expect the rupee to strengthen a bit by June. This optimism is derived from the fact that the dollar hasn’t begun to rise sharply yet. Also, the Indian debt market has attracted flows even while equities saw an outflow.
Nevertheless, the outlook for the Indian currency in the long term is weak as forecasters predict its fall to at least 66 by the end of the year, with the worst forecast being a drop to 68 to a dollar.
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