Macro Research. Conundrum of Indian Rupee. Strength of US Dollar and RBI Intervention Responsible for Weak Rupee. Currency.

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1 Strength of US Dollar and RBI Intervention Responsible for Weak Rupee Special Report Currency Rupee Movement Not in Sync with Macro Fundamentals: The movement of rupee-dollar exchange rate is not in sync with economic fundamentals, says India Ratings & Research (Ind- Ra). Indian economy, although not out of woods, has improved from mid-fy14. While the fiscal deficit exceeds FY08 s, the twin deficits are no longer a macroeconomic vulnerability. The outlook for medium-term growth, inflation, current account deficit (CAD) and interest rate has improved. All these factors could otherwise have led to a strong/stable currency. Strengthening US Dollar: The strong appreciation of the US dollar (USD; measured by US dollar Index) is mainly responsible for the weakening of the Indian rupee (INR). Broad US dollar index (BUSDI) appreciated 7.4% between January-December BUSDI for December 2014 (.4) is at 69 months high. USD has been gaining strength against other currencies due to i) robust recovery in the US economy, ii) withdrawal of quantitative easing (QE) by the US Fed and iii) continuation of the easy monetary policy followed elsewhere including Japan and euro zone. INR a Better Performing Currency: Between January-August 2013, the Indian rupee was the worst performing currency, by depreciating 21.4% against USD. However, INR was one of the best performing currencies between January-December While INR depreciated 3.3% during this period against USD, the currencies of other major countries such as Australia, Brazil, Canada, euro zone, Japan, Malaysia, Russia, Sweden, Switzerland and United Kingdom depreciated more than INR against USD. The euro has been trading at its lowest level (on 7 ) against USD since January 2006 on the expectation of a stimulus from the European Central Bank to pull the euro zone out of deflation and spur economic growth. Reserve Bank of India s (RBI) Intervention: India follows a managed float exchange rate policy. RBI s stated policy of intervention in the currency market is to check the unusual fluctuations in INR. However, the regulator s intervention lately suggest otherwise. INR depreciated from INR60.05/USD (monthly average) in July 2014 to INR62.74/USD in December This happened despite a strong net foreign institutional inflow of USD21.7bn during the same period. As per the latest data available, RBI bought USD19.4bn till the end- October Focus on Real Effective Exchange Rate (REER): Although there are many factors that impact exports, the value of currency is an important factor that determines the export competitiveness of a country. RBI s intervention in the currency market lately suggests that it is trying to keep the value of INR in a particular band based on REER. The fair value of rupee has been estimated in the range of INR61-62/USD based on REER. However, REER (36-currency bilateral trade weighted) suggests that the rupee was still overvalued by close to 10% in November Analysts Devendra Kumar Pant devendra.pant@indiaratings.co.in Sunil Kumar Sinha sunil.sinha@indiaratings.co.in Apurva Yadav 9

2 Backdrop Post the 2008 global financial crisis, there have been several instances of INR weakening suddenly against USD. While the mere mention of unwinding of QE by the US Fed played havoc with the rupee in mid-2013, this time the rupee remained relatively stable even after the announcement of QE unwinding in October INR depreciated 8.4% by end-december 2014 on a point-to-point basis from its highest value of INR58.43/USD on 19 May Although the CAD has widened lately due to a higher trade deficit, a higher inflow through the capital account has provided some cushion. As a result, the country added USD15.5bn to the forex till the week ended 26 December 2014 (USD12.2bn in FY14). Yet the rupee instead of strengthening has weakened, and was trading in the band of /USD during December Figure 1 Currency Movement (INR/USD) Strengthening of US dollar index 40 and RBI 35 Euro zone debt crisis intervention Aug 98 Jun 00 Apr 02 Feb 04 Nov 05 Sep 07 Jul 09 May 11 Mar 13 Dec 14 Source: Reserve Bank of India Likelihood of Fed tapering of QE Fear of euro zone break-up Before examining the current episode, a brief look at the weakness of rupee during mid-2013 may be useful. The Indian rupee went into a tailspin in July-August 2013 and recorded its lowest level of 68.34/USD on 28 August It recovered to 60.10/USD on 28 March Both weak economic fundamentals and speculation contributed towards the rupee weakening in mid Policy logjam, sudden stop of capital inflow, rising inflation, high CAD and strengthening USD, in general, were the main factors responsible for the rupee weakening. Until August 2013, the policy prescription of arresting the fall in rupee was to control dollar demand; however, this did not yielded desired results. However, with the change of the guard at RBI in September 2013, the policy focus shifted to the augmentation of supply of the US dollar. Some control on runaway gold imports and reduction in policy uncertainty also helped and the rupee staged a smart recovery by FYE14. The Indian rupee turned out to be one of the best performing currencies compared with the most fragile currency in mid Drivers of Exchange Rate Economic Fundamentals and Outlook Economic sentiments have improved considerably with the outcome of the general election 2014 in favour of a stable government. Macroeconomic indicators such as GDP growth, inflation, current account and fiscal deficit are likely to perform much better in both FY15 and the medium-term compared with FY13 and FY14. Although a lot will depend on how quickly India resolves the supply issues which affected its growth in FY13 and FY14. Related Research Economic Recovery: Gradual but on Course Rupee: Light at the End of the Tunnel While global recovery is still fragile and uneven, the outlook for the US economy is better than last year s. India and the US are the only two large economies of the world where IMF s September 2014 growth projections are higher than April 2014 projections. Earlier fears of an immediate Fed rate hike are now eased and it is widely expected that Fed rate hike cycle will start from mid-2015 with odds in favour of a gradual rate hike. Clearly, the tapering off of QE is 2

3 over and unlike mid-2013 the rupee withstood tapering off without any turbulence. Ind-Ra expects GDP to grow at 5.6% and average WPI inflation to decline to 2.7% in FY15. It also expects interest rate to decline to 7.8%-7.9% by FYE15. Current Account and Capital Inflow Currency movement is closely linked to the level of CAD and capital inflow. Although CAD in FY15 is likely to be higher than in FY14 (1.7%), capital inflow is estimated to be more than sufficient to finance the deficit. Ind-Ra expects foreign exchange reserve to increase by USD15.0bn in FY15. CAD in FY13 increased to 4.7% of GDP from 2.7% in FY11. This along with a slowdown of capital inflow resulted in weakening of the rupee. CAD in 1HFY15 came in at USD17.9bn (1HFY14: USD26.9bn) and forex reserve increased by USD10.0bn (down USD14.8bn). Yet rupee depreciated by 1.7% yoy during 1HFY15 and depreciated by another 2.6% between October and December Global Factors: Strengthening of US Dollar Global development particularly the status of USD in relation to other currencies is another factor that dictates the movement of rupee. BUSDI (trade weighted against 26 major trading partner of US, January 1997=) appreciated 3.2% yoy in 2014 and between January and December 2014, it appreciated by 9.0%. Strengthening of BUSDI has a strong negative correlation with the rupee-dollar exchange rate and results in rupee weakening. BUSDI for December 2014 (.4) is at 69 months high. Unlike mid-2013 when the rupee touched a record low due to the fear of QE tapering and domestic factors, this time around the depreciation in the rupee was mainly due to the strengthening of USD against other major currencies of the world and not the other way round. Figure 2 Movement of Major Currencies with respect to USD Countries Weights in US dollar index USD appreciation (+)/depreciation (-) Beginning January 2013 and end-december 2013 Beginning January 2014 and end-december 2014 Argentina Australia Brazil Canada Chile China Colombia Eurozone Hong Kong India Indonesia Israel Japan Malaysia Mexico Philippines Russia Saudi Arabia Singapore South Korea Sweden Switzerland Taiwan Thailand United Kingdom Venezuela BUSDI Source: Federal Reserve, and Ind-Ra During January-December 2014, barring Saudi Riyal, USD appreciated against all currencies of USDI (Figure 2). Appreciation was sharp against Russian, Argentinian, Columbian, Swedish, 3

4 Jan 12 Feb 12 Mar 12 Apr 12 May 12 Jun 12 Jul 12 Aug 12 Sep 12 Oct 12 Nov 12 Dec 12 Jan 13 Feb 13 Mar 13 Apr 13 May 13 Jun 13 Jul 13 Aug 13 Sep 13 Oct 13 Nov 13 Dec 13 Jan 14 Feb 14 Mar 14 Apr 14 May 14 Jun 14 Jul 14 Aug 14 Sep 14 Oct 14 Nov 14 Chilean, Brazilian, Japanese, Eurozone Israelis, Mexican and Swiss currencies. RBI s Intervention in Forex Market India broadly follows a managed float, whereby RBI intervenes in the forex market only to control unusual volatility. RBI is not an exception as central banks across the world intervene in the currency market to reduce volatility in their currencies. During the periods/years of strong capital inflow and outflow, RBI s intervention in the forex market was very high. In FY08, the regulator made a net purchase of USD78.2bn of foreign currency from market to check rupee appreciation. In FY11 and FY12, it intervened in the currency market to control the rupee depreciation and sold USD20.1bn and USD2.6bn, respectively. However, RBI s intervention in FY14 had two entirely opposite trends. In 1HFY14, it sold USD13.8bn in the currency market to defend depreciating rupee. However, after capital started flowing in after October 2013, it in 2HFY14 made a net purchase of USD22.8bn. In fact, the net purchase of foreign currency by RBI in November 2013 (USD10.1bn) was highest since January 2008 (USD13.6bn). Even during April-October 2014, it made a net purchase of USD19.4bn to arrest rupee appreciation. As the value of currency has a significant bearing on exports, preventing unusual volatility in its value to keep the country s exports internationally competitive has been one of the important policy objectives of RBI. However, lately it appears that RBI has started focusing on Consumer Price Index-based REER instead of nominal effective exchange rate (NEER) of rupee. Based on REER, the fair value of rupee is estimated to be in the range of INR61-62/USD. RBI s recent intervention in the currency market is focused towards maintaining the rupee in this band, although November 2014 REER (36-currency bilateral trade weighted) suggests that the rupee is still overvalued by close to 10%. NEER depreciated 3.3% between April-November 2014, while REER depreciated 5.9%. This was due to higher inflation in India than trading partners. However, REER is stable now with inflation declining lately. Ind-Ra expects the inflation to remain benign in the near to medium term. As this will provide stability to REER, RBI s intervention in the currency market would be based mainly on capital inflow and CAD. Figure 3 36 Country Trade Weighted REER, NEER and RBI's Intervention Since 2HFY14, RBI's intervention has been to limit appreciation of rupee (FY05=) REER (LHS) NEER (LHS) RBI intervention (RHS) (USDbn) Source: RBI, CSO and Ind-Ra 4

5 Appendix Movement of Currencies in BUSDI against USD Figure 4 Figure 5 Canadian Dollar (Jan 1997 = ) USD/CAD(RHS) (2 Jan 2013 = ) Japanese Yen USD/JPY (RHS) (Jan 1997 = ) (2 Jan 2013 = ) Figure 6 Figure 7 Euro South Korean Won (Jan 1997 = ) USD/EUR (RHS) (2 Jan 2013 = ) (Jan 1997 = ) USD/KRW(RHS) (2 Jan 2013 = ) 85 Figure 8 Figure 9 Australian Dollar Malayasian Ringgit (Jan 1997 = ) USD/AUD (RHS) (2 Jan 2013 = ) (Jan 1997 = ) USD/MYR(RHS) (2 Jan 2013 = ) 5

6 Figure 10 Figure 11 Argentine Peso (Jan 1997 = ) USD/ARS (RHS) (2 Jan 2013 = ) Mexican Peso USD/MXN(RHS) (Jan 1997 = ) (2 Jan 2013 = ) Figure 12 Figure 13 British Pound Philippine Peso (Jan 1997 = ) USD/GBP (RHS) (2 Jan 2013 = ) (Jan 1997 = ) USD/PHP (RHS) (2 Jan 2013 = ) Figure 14 Figure 15 Brazilian Real USD/BRL (RHS) (Jan 1997 = ) (2 Jan 2013 = ) 140 Russian Ruble USD/RUB(RHS) (Jan 1997 = ) (2 Jan 2013 = )

7 Figure 16 Figure 17 Chilian Peso Singapore Dollar (Jan 1997 = ) USD/CLP (RHS) (2 Jan 2013 = ) (Jan 1997 = ) USD/SGD(RHS) (2 Jan 2013 = ) Figure 18 Figure 19 Chinese Yuan Saudi Riyal (Jan 1997 = ) USD/CNY(RHS) (2 Jan 2013 = ) (Jan 1997 = ) USD/SAR(RHS) (2 Jan 2013 = ) Figure 20 Figure 21 Colombian Peso (Jan 1997 = ) USD/COP (RHS) (2 Jan 2013 = ) Swedish Krona USD/SEK (RHS) (Jan 1997 = ) (2 Jan 2013 = ) 125 7

8 Figure 22 Figure 23 Indian Rupee Swiss Franc (Jan 1997 = ) USD/INR (RHS) (2 Jan 2013 = ) (Jan 1997 = ) USD/CHF (RHS) (2 Jan 2013 = ) Figure 24 Figure 25 Indonesian Rupiah New Taiwan Dollar (Jan 1997 = ) USD/IDR (RHS) (2 Jan 2013 = ) (Jan 1997 = ) USD/TWD(RHS) (2 Jan 2013 = ) Figure 26 Figure 27 Israeli New Shekel USD/ILS (RHS) (Jan 1997 = ) (2 Jan 2013 = ) Thai Baht USD/THB(RHS) (Jan 1997 = ) (2 Jan 2013 = ) 8

9 Figure 28 Figure 29 Hongkong Dollar USD/HKD (RHS) (Jan 1997 = ) (2 Jan 2013 = ) Venezuelan Bolivar USD/VEF(RHS) (Jan 1997 = ) (2 Jan 2013 = )

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