Rupee Outlook. Treasury Research Group For private circulation only. Key factors that have led to the Rupee strength :

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1 Rupee Outlook Treasury Research Group For private circulation only Rupee: Stronger now, weaker later Indian Rupee has been one of the better performing EM currencies in This performance is supported by the benign global financial market environment and improved political landscape domestically. The reform push has received a major thrust with the implementation of the long awaited GST bill. We are revising our Rupee outlook to for the current fiscal year with a variation of +/- 2%. This level is stronger as compared to the previous forecast of by March 2018 but weaker from the current levels of In this note we highlight the key factors that are expected to drive Rupee trajectory from the short/medium term perspective. Key factors that have led to the Rupee strength : Dollar has underperformed vis-à-vis expectation: Though potential withdrawal of global liquidity may has disruptive implications for financial markets, overall trend till now has been benign. The political leadership in US has failed to capitalize on the expectation of the strong reform push and the Trump trade has faded. Also indication by other major central banks to move away from easing stance has also led to weaker Dollar. This disappointment has led to ~9% depreciation in the Dollar on a FYTD basis. Meanwhile the Euro has witnessed a sharp rally and all the major risky assets have performed well over the last few months. Yuan volatility has subsided amid increase in FX reserves: Chinese FX reserves has been rising for the sixth consecutive month and climbed to USD 3.08 tn in July. The increase in FX reserves should lend support to the Yuan and limit the volatility. Given the importance of China in driving stability in Asian markets, we believe that near term outlook for the Rupee is favourable. August 8th, 2017 Samir Tripathi Samir.tripathi@icicibank.com Please see important disclaimer at the end of this report Strong capital flows in the domestic economy: Given the benign global environment, India has received ~USD 15 bn in the current fiscal out of which ~USD 13.2 bn is in the debt and remaining in equities. The high real interest rate has incentivized the exporters to sell Dollar at a time when importers are not hedging. This has further supported the Rupee. In fact, Indian Rupee has generated highest total return (i.e. Carry return and spot return combined) as compared to other EM peers. Key factors that will drive Rupee trajectory going forward : Major global central banks have indicated their intention to move away from easing stance: While the Fed is expected to start reducing the balance sheet over the next few months, the ECB is expected to indicate the roadmap for withdrawing stimulus. Further tapering indications are likely to be announced soon. Other developed economy central banks too are changing the course. While the Bank of Canada has raised the policy rate by 25 bps in July, Australian central bank has signalled that the rate easing cycle is over in the recently concluded policy meeting. Though we expect the muted volatility in the financial market to persist in the immediate near term, the medium term outlook remain uncertain. US debt ceiling limit another source of uncertainty from the financial market perspective: In this regard, the evolution of the political economy in US is crucial. Besides the Fed action plan in terms of balance sheet reduction as well as rate hikes, market focus will shift to debt ceiling limit, which is likely to be hit in early October. The Treasury secretary has urged the Congress to raise the debt ceiling by September end but political uncertainty might delay the process. Overall we believe that the Congress will either raise the debt ceiling to a new higher level, or it can suspend the ceiling until some date in the future. The interim period is expected to be uncertain.

2 On the domestic front though external sector outlook remain robust, current account is worsening on the margin: We expect a higher CAD of ~1.7% of the GDP in FY 2018 (vs. 0.7% in FY2017) amid sharper growth in imports, especially non-oil non-gold. Meanwhile only incremental improvement is expected from exports amid relatively strong Rupee and muted growth prospects in the Middle East region, one of India s largest trading partners. Meanwhile strong FDI related flows are expected to continue amid strong push by the Government. Overall we believe that the basic balance (CAD+FDI) is expected to turn negative after three consecutive years of surplus. Risk to portfolio flows remains: Incremental flows in the debt segment is limited given the fact that utilization limit is almost exhausted for central Government securities and corporate bonds at 99% and 92% respectively. However the utilization limit is minuscule for State loans and there is scope for increased investment there. The high flows into the debt segment are also driven by the high real interest rate and stable to strong Rupee. Going forward, this is likely to be a less supportive factor as we believe that real interest rate has peaked and is expected to come down as inflation trajectory rises. Meanwhile, stretched valuation in the equity segment limits the scope of significant flows into the equity segment, though incremental flows are expected on account of the new ETF called Bharat 22 index and some upcoming IPOs like GIC. RBI to continue with the FX intervention strategy: RBI has possibly intervened to the tune of USD 26.4 bn in the first half of the calendar year out of which ~USD 11 bn is in spot and USD 15 bn in forward. Meanwhile the ability of the central bank to intervene in the spot market is expected to receive a boost, on account of the proposed extension of the MSS ceiling. We are cognizant of the widening trade deficit and likelihood of external shock as the global liquidity scenario is expected to tighten in the medium term. This is warranted to stem the appreciation bias in the currency. Also the highest ever over valuation of the Indian Rupee on 36 and 6 country basis is another consideration for Rupee intervention. We believe that there is scope to further build FX reserves. Adding the FX reserves (USD bn) and forwards (USD 13.6 bn) the total comes to ~USD 405 bn which is close to the long term average of ~11 times import cover. Conclusion: Revising the Rupee outlook With all the factors under consideration, we are revising our Rupee outlook to for the current fiscal year with a variation of +/- 2%. The depreciation bias in the Dollar index over the last few months amid rising political uncertainty domestically and major central banks moving away from the easing stance have been the key driver for the change in view. Reduced Yuan volatility amid increase in FX reserves in China has also been supportive for Rupee trajectory. External shocks led by the Fed unwinding or any triggers from the ECB continue to remain the key risks to the outlook. Key data prints to support the arguments are as follows: Indian Rupee has outperformed other EM currencies w.r.t to total return Yuan volatility has subsided amid increase in FX reserves * +/- is appreciation/depreciation 2

3 Aug-14 Oct-14 Dec-14 Feb-15 Apr-15 Jun-15 Aug-15 Oct-15 Dec-15 Feb-16 Apr-16 Jun-16 Aug-16 Oct-16 Dec-16 Feb-17 Apr-17 Jun-17 Aug-17 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 FY2011 FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 FY2018 (E) Real rates have peaked and expected to come off amid expectation of rising CPI inflation Basic balance is expected to turn negative after three consecutive positive years (USD bn) 40 Basic balance (CAD+FDI) FII flows have been strong led by the Debt related inflows (USD bn) Portfolio flows Debt Equity Rupee over valuation is highest as compared to the long term average (% YoY) Overvaluation/Undervaluation of REER 36 country 6 country Over valuation Under valuation The overvaluation/undervaluation is calculated based on REER vis-à-vis the long term average 3

4 ICICI Bank: ICICI Bank Towers, Bandra Kurla Complex, Mumbai Phone: (+91-22) Treasury Research Group Economics Research Sunandan Chaudhuri Senior Economist (+91-22) Kamalika Das Economist (+91-22) (ext 6280) Samir Tripathi Economist (+91-22) Pradeep Goyal Economist (+91-22) (ext 6229) Sumedha Dasgupta Economist (+91-22) (ext. 7243) Renuka Khadke Economist (+91-22) (ext. 8976) Ramakrishna Reddy Economist (+91-22) (ext. 6943) Bogathu Ashray Ohri Economist (+91-22) (ext. 7206) Sri Virinchi Kadiyala Economist (+91-22) (ext. 7206) Pradeep Kumar Economist (+91-22) (ext. 6272) Sparsh Chhabra Economist (+91-22) (ext. 6309) Yash Panjrath Economist (+91-22) (ext. 6309) Treasury Desks Treasury Sales (+91-22) Currency Desk (+91-22) Gsec Desk (+91-22) FX Derivatives (+91-22) /43 Interest Rate Derivatives (+91-22) Commodities Desk (+91-22) Corporate Bonds (+91-22)

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