Rupee Outlook. INR: Benign global environment supporting near term appreciation; fundamentals to drive medium term trajectory

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1 Rupee Outlook Treasury Research Group For private circulation only INR: Benign global environment supporting near term appreciation; fundamentals to drive medium term trajectory Chart : Average Rupee return (FY 2011-FY 2018*) INR is expected to remain supported in Q4 FY2018 amid benign global financial market condition and seasonal factors domestically Worsening basic balance amid widening CAD to result in mild depreciation in FY 2019 INR has appreciated during 2017 supported by improving global macro backdrop and strong capital flows. In this note we highlight the key global and domestic factors that are likely to drive the INR trajectory in the near and medium term. Near term outlook: INR to remain supported amid benign global environment We expect INR to appreciate below the 64 mark in Q4 FY2018. Seasonal trends are expected to favor a stronger INR. There is some tolerance to allow for INR appreciation especially in a scenario of rising inflation. Further, given the appreciation bias in other EM currencies, INR is likely to remain supported. *Q3 FY 2018 is till current date Source: RBI, ICICI Bank Research December 22nd, 2017 Samir Tripathi Samir.tripathi@icicibank.com Please see important disclaimer at the end of this report Benign global financial market environment On the global front, markets have been on a risk on mode through the course of 2017 amid synchronized strength in the advanced economies, recovery in EM economies and low inflation environment in the developed economies. We expect the major central banks to only gradually remove the massive monetary stimulus which is expected to keep global liquidity ample. Phillips curve, which captures the inverse relation between the unemployment rate and inflation, seems to have become less sensitive in the US and is keeping the expectation of sharper pace of rate hikes by the Fed in check. Unless this changes, weakness in Dollar, strong capital flows to EM economies and broad risk on trade is likely to persist. Medium term outlook: India s external sector outlook worsening on the margin On the domestic front, we expect a higher CAD of ~1.7% of the GDP in FY2018 (vs. 0.7% in FY2017) amid sharper growth in imports. The trend is expected to further worsen in FY2019 as well. We believe that the basic balance (CAD+FDI) is expected to turn negative after three consecutive years of surplus. This trend will persist in FY 2019 as well. Besides the CAD, the best of the other macro variables such as inflation and fiscal have also started to deteriorate. Any further pickup in crude prices has the potential to further worsen not only CAD but also inflation and fiscal position. Conclusion: Near term appreciation to pave way for mild depreciation in FY2019 In Q4 FY 2018 we expect INR to appreciate on seasonal factors, greater tolerance for Rupee appreciation in line with other EM currencies and limited RBI intervention to stem inflationary pressure. From the medium term perspective, we believe that India s macro backdrop (ex growth) is worsening on the margin. Any pickup in crude prices will further accentuate the problem. Overall we expect INR to trade in the range of with the March end level of 65 in FY2019. While the Rupee is not likely to realize its 1Y forwards but there will be some depreciation bias.

2 INR: Benign global environment supporting near term appreciation; fundamentals to drive medium term trajectory INR has appreciated during 2017 supported by improving global macro backdrop and strong capital flows. On the domestic front, the political landscape has been favorable. In this note we highlight the key global and domestic factors that are likely to drive the INR trajectory in the near and medium term. Near term outlook: INR to remain supported amid benign global environment Chart : Average Rupee return (FY 2011-FY 2018*) *Q3 FY 2018 is till current date Source: RBI, ICICI Bank Research We expect INR to appreciate below the 64 mark in Q4 FY2018. Seasonal trends are expected to favor a stronger INR. Historical trend suggest that INR has appreciated during the 4th quarter. The strength in INR has been supported by the lowest possible current account deficit (CAD) and strong capital flows i.e. portfolio flows. We think that this trend will continue to persist in the current fiscal as well amid lower CAD relative to other quarters and strong equity related capital flows. Improvement in growth prospects and announced capital raising plans of some major corporates are expected to support equity related flows. Though RBI has aggressively intervened in the FX market we believe that there is some tolerance to allow for INR appreciation especially in a scenario of rising inflation. Spot and forward intervention might also be limited on the likely improvement in domestic liquidity scenario in Q4FY2018 and a significantly large outstanding Net Forward book (i.e. USD 31.3bn). Further, given the appreciation bias in other EM currencies, INR is likely to remain supported. Benign global financial market environment On the global front, markets have been on a risk on mode through the course of 2017 amid synchronized strength in the advanced economies, recovery in EM economies and low inflation environment in the developed economies. This environment absorbed the threat of prevalent geopolitical tensions and gradual withdrawal of monetary stimulus by the major central banks. Dollar to trade with a mild depreciation bias in the near term In the US, the FOMC has raised the policy rate 3 times in 2017 and initiated the balance sheet reduction program, despite which the Dollar trajectory was on a depreciating path. Further, the tax reforms passed by the US policy makers too have had limited impact on the Dollar. The evolution of the macro backdrop is the prominent theme driving the Dollar trajectory in our view. Phillips curve, which captures the inverse relation between the unemployment rate and inflation, seems to have become less sensitive in the US and is keeping the expectation of sharper pace of rate hikes by the Fed in check. The December FOMC economic projection too points toward the flattening of the Phillips curve in While the growth forecast has been revised higher, inflation is expected to remain muted in Unless this changes, weakness in Dollar, strong capital flows to EM economies and broad risk on trade is likely to persist. Global liquidity to remain ample We expect the major central banks to only gradually remove the massive monetary stimulus put in place since the financial crisis. The Fed interest rate hikes has been relatively gradual as compared to the previous cycle of Further the asset reduction by the Fed is likely to be modest in 2018, while the ECB is set to continue its QE purchases, albeit at a lower pace of EUR 30bn/month. Meanwhile, the BOJ is expected to continue its highly accommodative policies for a considerable time as inflation pressures remain 2

3 muted. In light of the modest scaling back of central bank balance sheets, global liquidity is likely to remain ample for some time. Medium term outlook: India s external sector outlook worsening on the margin On the domestic front, we expect a higher CAD of ~1.7% of the GDP in FY2018 (vs. 0.7% in FY2017) amid sharper growth in imports. The trend is expected to further worsen in FY2019 as well. The robustness of global growth prospects are expected to limit the widening of CAD. Meanwhile strong FDI related flows are expected to continue amid strong push by the Government. On the margin we believe that the basic balance (CAD+FDI) is expected to turn negative after three consecutive years of surplus. This trend will persist in FY 2019 as well. Capital flows have been strong amid benign global environment. On a FYTD basis, capital inflows have been relatively strong at ~USD 19.8 bn led by strong debt related flows (i.e. USD 18.3 bn). Incremental flows in the debt segment is limited given the fact that utilization limit is almost exhausted for central Government securities and corporate bonds. However the utilization limit is miniscule for State loans and there is scope for increased investment there. Enhancement of debt limit and a likely road map before next fiscal might pave the way for further investment in this category. The high flows into the debt segment were also driven by the high real interest rate. Going forward, this is likely to be a less supportive factor as we believe that real interest rate has peaked and has come down given the recent rise in inflation trajectory. Meanwhile, FII flows in the equity segment might gain traction as growth prospects improve. However, we note that the stretched valuation in the equity segment might limit the scope of significant inflows. Besides the CAD, the best of the other macro variables such as inflation and fiscal have also started to deteriorate. Any further pickup in crude prices has the potential to further worsen not only CAD but also inflation and fiscal position. Also, the expectation of a populist budget in FY 2019 has increased recently, which might also deter sentiment. In this context, we expect INR to trade with a gradual depreciation bias. Overall we expect INR to trade in the range of with the March end level of 65 in FY2019. While the Rupee is not likely to realize its 1Y forwards but there will be some depreciation bias. On the global front, markets are pricing in continuation of low inflation in US for an extended period of time. We believe there is risk to the view given the expectation of strong growth, tight labor market condition, pickup in commodity prices and loose fiscal policy. If this scenario materializes, there is a case of market re-pricing which has the potential to push US rates higher and lead to volatility in EM capital flows. Conclusion: Near term appreciation to pave way for mild depreciation in FY2019 In Q4 FY 2018 we expect INR to appreciate on seasonal factors, greater tolerance for Rupee appreciation in line with other EM currencies and limited RBI intervention to stem inflationary pressure. From the medium term perspective, we believe that India s macro backdrop (ex growth) is worsening on the margin. Any pickup in crude prices will further accentuate the problem. Overall we expect INR to trade in the range of with the March FY 2019 level of 65 in FY

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