The recent disturbances in rupee value point towards the typical idiosyncrasies associated with a financial market. While, a large part of the decline is in consonance with the global strengthening of the USD against emerging market currencies, India could not have been immune to such.
However, the pace of currency depreciation in recent times seemed to have rattled the markets. For example, it took only one trading day for the rupee to travel 100 paisa a day in August, as against a historical average of 17 days beginning April 2018 (27 days in 2015). While it may be preposterous to use terms like Indian currency being one of the worst performers across Asian peers, it is a fact that rupee has depreciated by close to 14% in 2018, as against 9.6% for Indonesian Rupiah, against which a comparison is often made as both are CAD countries. But the 5-year Credit Default Swap (CDS / a possible proxy for country risk) for India has widened only half of what Indonesia has witnessed in 2018. Interestingly, even for Malaysia, the change in CDS is much more than India and intriguingly Malaysian Ringgit has depreciated by only 3.1% in 2018. Clearly, the current precipitous fall in rupee value does not in any way contradict the investor perception of India being a relatively safe investment destination.
The trigger for the sudden rapid decline in rupee value came after the trade data for July showed a 5 year high $18 bn deficit. We believe, apart from price impact, oil importers’ frontloading of oil imports from Iran ahead of the US sanctions, which hit a record 768,000 barrels per day in July, was also one of the reasons why the trade deficit has been widening in recent months. It may be noted that India, China and Turkey import around 67% of Iranian oil exports.
There are two perceived benefits of rupee depreciation in the form of increased exports and automatic adjustment of trade deficit in policy circles which are currently being vigorously talked about. We believe the traditional view that weak exchange rates could dramatically boost exports growth is not entirely correct over the long term as India’s export basket has changed significantly from traditional products to more mechanised engineering goods over the years, thus making them more income elastic rather than price elastic.
In the hope of a better export growth, talking down the rupee as was done recently when the markets were volatile might have been counterproductive and thus the pace of depreciation picked up frantic pace in the last week or so. In this context, the statement by FM is most welcome and timely one as it has provided an immediate succor to battered market sentiments. The RBI could also chip in with a message that could be most comforting under the current circumstances. It may be noted that RBI intervention in the foreign exchange market recently have been limited given the costs associated with such.
So what next? We believe that beyond a point, the costs of rupee depreciation will significantly outweigh the benefits from such and the policy makers should be mindful of such. There are many. First, India’s short term debt obligations at $222 billion due on March 2018 if rolled over could add a significant cost on the government. Second, oil import bill could go up manifold.
Third, with yields increasing, this could add up government fiscal costs too and also put enormous pressure on beleaguered Indian banks in terms of ratcheting up MTM losses. It may be noted that the yields are already under pressure as unlike earlier years, the government borrowing programme is not frontloaded in the current fiscal.
Most importantly as per RBI estimates, assuming a 10% depreciation, this could add upto 50 bps on inflation number. In fact, continued rupee depreciation could result in rate action by RBI in October policy, even as headline CPI will decline meaningfully to 3.6-3.7% in September.
But there are positives, too. A history of Indian foreign exchange market shows that foreign portfolio investment (FPI) generally responds negatively to domestic currency depreciation over a period of time. This is obvious, as a typical portfolio investor brings in foreign currency but invests in domestic currency and therefore a depreciation in domestic currency will only mean that a portfolio investor will be able to take out a lower amount of foreign currency compared to what was originally invested. Portfolio investors thus have a typical asymmetric behavior as they behave oppositely to appreciation and depreciation of the domestic currency.
To sum up, future movements of rupee value will be mostly dictated by movement in USD, even as the NDF market still shows rupee could continue to be under pressure.
Tightening financial market conditions make us believe that the US Federal Reserve will remain largely cautious over the pace of monetary tightening. For example, Fed Chairman Powell in his speech at Jackson Hole on 24th August concluded that “there does not seem to be an elevated risk of overheating”.
The failure of the dollar to advance significantly after such statement indicates that the recent elevated levels are not sustainable.
Independent estimates suggest that there is significant speculative long dollar positioning, implying USD may weaken going forward. Additionally, going forward, macro numbers are also not favourable for continued USD strengthening.
There is a record level of indebtedness in the global economy. It is not just the amount of public and private debt which is worrying, but also the deterioration in average quality. There is now $63 trillion of sovereign debt outstanding, with total debt at $237 trillion, a full $70 trillion above pre-Lehman levels!
Clearly, we should stay calm for now, even as rupee stays under pressure. But no harm in initiating measures to improve India’s trade deficit as in Indonesia and the RBI intervening and talking up the rupee in the interregnum.