INR: Free falling. Currency Outlook- INR

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1 Currency Outlook- INR Treasury Research Group For private circulation only INR: Free falling Chart 1: FPI outflows have intensified in 2018 After a strong performance over 2017, the INR has come under strong selling pressure in Given the current environment of rising crude oil prices and concerns about the domestic macroeconomic landscape, we do not rule out the USD/INR pair testing the 67 levels in the near-term. The RBI could stepup intervention to ensure that depreciation is not disorderly. While a possible pull-back in oil prices as the supply of oil picks up over the medium term could reduce some of the pressures, we continue to expect lower capital inflows because of deteriorating INR fundamentals. Hence, we do not expect a substantial pull-back in the USD/INR pair over the medium term. However, the possibility of a weaker USD because of the twin-deficit problem could restrain depreciation pressures over the medium term. Source: Reuters & ICICI Bank Research After a strong 2017, the INR has started to weaken in 2018 After a strong end to 2017, the story for the INR has been very different in While the INR started to gradually weaken decoupling from the AXJ group (Asia excluding Japan) over January-February-2018, depreciation pressures have intensified over the last fortnight driven by the following factors: April 24, 2018 Shivom Chakravarti shivom.chakravarti@icicibank.com Domestic macro data flow turned somewhat adverse as CPI inflation surprised to the upside and the trade deficit widened over March Global risk sentiment deteriorated in response to the protectionist stance of the US government and possibility of global trade-wars. There was a sharp deterioration in sentiment towards domestic bond markets as: (a) participants remain somewhat uncertain about future trajectory of domestic inflation and (b) uncertainty about domestic monetary policy given the mixed messages being provided by the RBI. Hence, debt outflows via the FPI route gathered momentum putting the INR under pressure. The final nail in the INR coffin came from a sharp appreciation in global crude oil prices. To further add to the INR s woes, US sovereign yields have started to tick higher working against all EM currencies as capital gets re-allocated into the US markets. Please see important disclaimer at the end of this report Hence, there has been a dual hit to both the current account and capital account resulting in sharp depreciation in the INR. FPI outflows have been around USD 2 bln in April-2018 while total FPI inflows over January-April-2018 has been around USD 0.4 billion compared to FPI inflows of USD 14 billion in the same period last year. The RBI for its part has intervened to protect the exchange rate by selling USDs and that could continue in the near-term as long as depreciation pressures persist. However, it is unlikely that RBI intervention will work as a trend reversal given the outflow pressures that persists in the near-term.

2 Chart 2: The INR has decoupled from its peer group in Chart 3: emerging as one of the underperforming EM currencies Note: USD/AXJ = Average (IDR, KRW, MYR, PHP, THB, TWD, SGD) against USD Both USD/AXJ and USD/INR have been re-based to 100 with 2010 as the base-year Source: Reuters & ICICI Bank Research Near-term: INR momentum to be driven by oil prices The uncertainty about the future trajectory of global crude oil prices is likely to keep the INR under pressure in the nearterm. While the current move in crude oil prices is being driven by short-term supply disruptions because of geopolitical tensions and developments in the Middle-East and Venezuela, there is growing anxiety that these short-term disruptions could become more permanent in nature resulting in a higher equilibirum trading range for crude oil prices. The upshot is that as long as uncertainty persists about the future direction of global crude oil prices, the INR is likely to remain under pressure. We do not rule out a possibility of the USD/INR pair moving towards and even breaching the 67 mark in the near-term. Chart 4: Supply of oil expected to pick-up in H22018 Source: IEA, EIA & ICICI Bank Research Despite the recent uptrend in global crude oil prices and uncertainty about the future trajectory, we maintain our view that they could settle lower over the medium term. We view the recent upward move driven primarily by concerns about the supply of oil. However, we think that the US shale output could pick-up in the medium term and that some of these geo-political concerns such as those related to US-Iran nuclear deal could subside. Hence, ensuring that there is not substantial supply disruption in the medium term resulting the Brent Crude oil prices averaging of USD 64/barrel for This in turn could ease some of the pressures on the INR. The problem is that the vulnerability of the INR does not end with crude prices alone. We fear that the fundamentals of the INR are likely to turn more unfavourable over the medium term that suggests that any pull-back could remain limited even if crude prices settle lower. 2

3 Domestic inflation: to act as a headwind Domestic CPI inflation is expected to accelerate over FY19. Core inflation pressures could pick-up in response to improving domestic demand and a narrowing of the domestic output gap. Food price inflation is expected to head higher but could rise sharply if the government moves ahead with its plans for an increase in MSPs. We forecast CPI inflation to move towards the 5.5% mark by June-2018 and average around 4.7% over FY19 but these forecasts do not include the possibility of the government increasing MSPs. Were the government to move ahead with its plans, CPI inflation could be higher than we are currently forecasting. Historically, the INR has broadly moved in sync with inflation differentials. Rising inflation differentials tend to result in depreciation pressures due to competitiveness problems. A similar scenario is likely over Chart 5: Wider inflation differentials tends to put the INR under pressure Source: IMF & ICICI Bank Research Other domestic risks that could restrain capital flows There still remains some uncertainty about whether the government will be able to meet its fiscal deficit to GDP target of 3.3% for FY19 even as GST revenues look optimistic. Besides, some apprehensions are also likely to build-up in a runup to the general election around the end of 2018 as investors wait for the formation of the new government. The problem is that these set of concerns, despite expectations of stronger domestic growth prospects, could force investors to shy away from domestic assets at least until the final outcome is known. Global risk environment more challenged in The story of 2017 was that of synchronized global growth accompanied by an accommodative global monetary environment that kept risky assets, such as Indian assets, in demand. However, the trading environment is likely to be different going into The combination of concerns about global protectionism policies, an uncertain geo-political environment and a gradual tightening in the global monetary environment are likely to result in a more challenged risk environment. As investors grapple with the slew of risks, capital flows into EM markets such as the Indian markets are likely to be lower over than was the case in the previous fiscal year. Medium term: A tussle between worsening INR fundamentals & US twin deficits In short, the domestic balance of payments is likely to deteriorate given the possible widening in the trade deficit and lower FPI flows. However, given our view of a broadly weak bias on the USD over the medium term driven by the twin deficit problem and robust domestic FX reserves that will allow the RBI adequate room to keep depreciation pressures in check should cap extreme depreciation pressures over the longer-term. 3

4 (USD bn) Chart 6: BOP likely to deteriorate India's Balance of Payments FY2017 FY2018 (E) FY2019 (E) Merchandise Exports Imports Invisibles Services Transfers Income Total Current Account (% of GDP) Foreign Investment FDI Portfolio Investment Loans Banking Capital Other capital Total Capital Account* Overall BoP (* includes errors and omissions) Source: RBI & ICICI Bank research 4

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