Weathering the Indian rupee storm
Also published on Bloomberg, September 27, 2018
- The Indian rupee (INR) has been the worst performing currency in Asia, losing more than 12% against the US dollar compared to the beginning of the year and registering a historic low of 72.7 against the USD in September.
- We use two approaches to delve deeper into the fundamentals of the INR and assess whether the current weak levels are justified.
- Given the outcome of our EM Vulnerability Heatmap, models and expected additional policy interventions, we expect strengthening of the Indian rupee in the short term
- The big question is if the RBI will step up its efforts to support the INR with its monetary policy. In the October MPC we believe that the RBI will raise its rates by 25bps for two reasons. First, the inflationary pressure in India is far from gone. Second, the RBI cannot run the risk to under-deliver, especially with the current nervousness on financial markets
The second quarter of fiscal 2018/2019 was a stormy one in several ways. Not only did the hurricane and cyclone season reach its peak in September, causing a swath of destruction on the East Coast of the US (Florence) and in Southeast Asia (Mankhut). Emerging market currencies have been weathering quite a storm in Q2 as well (figure 1). A combination of factors were at the root of the global sell-off of emerging market assets in the last couple of months, such as the intensifying US-China trade war, the drain of global dollar liquidity by the Fed, stubbornly high oil prices and country-specific events in Turkey (concerns about central bank independency and inflation), Brazil (upcoming elections), South Africa (elections) and Argentina (low reserves, high inflation).
Especially the country-specific events seems to have exacerbated the adverse sentiment of investors towards emerging markets in general. Apparently, investors are still putting the so-called ‘fragile five’ countries from taper tantrum in one asset class. The Indian rupee (INR) has been the worst performing currency in Asia, losing more than 12% against the US dollar compared to the beginning of the year and registering a historic low of 72.7 against the USD in September. The question we ask ourselves in this column is this: is the heavy sell-off of the INR justified based on the economic fundamentals? Time to grab our rain coat and rubber boots and do some field work.
Approach 1: the EM weather radar
It is a bit strange to bring up the term heatmap when trying to get a grip on storms, so let’s refer to our first approach as the emerging market weather radar (which is basically still just a heatmap: see table 1). This tool is convenient to internationally benchmark the fundamentals that are generally considered to be driving investor appetite for emerging market assets. These fundamentals consist of three pillars: economic fundamentals (e.g. the current account deficit as a % of GDP, political risk, competitiveness), debt vulnerability (e.g. external debt as a % of GDP, non-financial corporate debt denominated in foreign currency) and financial market indicators (e.g. market liquidity, volatility and ‘hot money’).
Without going into details on the results or methodology of the weather radar, it becomes apparent that India is not among the best performing emerging market in terms currency fundamentals, but certainly not among the worst performers either (figure 2). This underlines that relatively healthy emerging markets, such as India and Indonesia, have been dragged into the current EM currency turmoil by countries performing much worse.
Approach 2: economic modelling
Just as national meteorological institutes use models to predict the weather, we can rely on economic models to predict the trajectory of the INR based on the underlying fundamentals. In this report we give a detailed description of a newly-developed two-equation iterative model, which integrates a portfolio investment equation with an error-correction equation for the INR.
Our model predicts that in the medium to longer term, India should brace for more rupee weakness due to a further pickup of inflation, structurally lower portfolio inflows and a further rise in oil prices. Ultimately, the steady state rate of INR would lie somewhere around 74 (figure 3). However, we expect the depreciation toward this steady state to be a very gradual process which fits the pattern of a fast-growing emerging market. So, this is not something to worry about.
The speed with which the INR has been sliding recently is worrying though. Where the INR currently hovers between 72 and 73, our models arrive at levels of 67 based on the fundamentals. This means that the large gap between the current value of the rupee and the predicted values is solely driven by bearish investor sentiment. When the dust has settled and investors will re-assess their portfolios based on these fundamentals, one could expect some strengthening of the INR.
Four scenarios for the INR
What’s more, scenario analyses shows that we need to make quite bold assumptions, such as an economic shock comparable with the impact of demonetisation in combination with a severe oil price shock, to justify INR levels seen in September (figure 4). This underlines our main conclusion that the current levels of the INR are out of sync with its fundamentals and the current weakness is mainly driven by market sentiment.
Of course, things can also take a turn for the worst. In a cumulative stress scenario - which encompasses an economic shock similar to demonetisation, an oil price shock, an acceleration of the Fed tightening cycle and political turmoil - capital flight from India would accumulate to more than INR 1000bn until early 2020 and this would push the rupee to levels close to 77.
The INR rate is not completely at the mercy of external factors. The Indian government has been pursuing different strategies to prop up the rate of the INR. On Friday 14 September, Finance Minister Arun Jaitley announced that the government will curb non-necessary imports, boost export, stay committed to the fiscal deficit target of -3.3% for this fiscal year and stimulate capital inflows by relaxing rules for foreign investment. So far, the measures have hardly resulted in strengthening of the INR and we certainly expect more government announcements going forward.
The butterfly effect
The big question is if the RBI will step up its efforts to support the INR with its monetary policy. The RBI has already been using INR 25bn to intervene on the foreign exchange market in the last couple of months. But there is no clarity as to what the RBI is going to do with its most important policy rates in the October Monetary Policy Committee (MPC). Admittedly, inflation has been on a downward trajectory and with inflation targeting as its main policy objective, one might expect the RBI to keep its rates on hold. We instead believe the RBI will raise its rates by 25bps for two reasons. First, the inflationary pressure in India is far from gone. The low inflation rates in July (4.2%) and Augustus (3.7%) were mainly due to very favourable food price developments and high core inflation of 6% should be taken as a sign on the wall. Second, and this is even more important, the RBI cannot run the risk to underdeliver, especially with the current nervousness on financial markets. Just as the flap of a butterfly in Brazil could metaphorically set off a tornado in Texas (to quote Edward Lorenz), a failed attempt by the MPC to reassure the markets in October could easily spur another storm of capital outflow, result in further rupee weakness and prop up inflationary risks.
 The fragile five are Brazil, Indonesia, India, South Africa and Turkey.
 Domestic dynamics at the moment have been so strong that the output gap has closed far more quickly than expected. The result is that ongoing high domestic dynamics will also continue to put upward pressure on price levels.
 In this scenario, we assume that market expectations will not weaken the actual fundamentals of the Indian economy too much. Such a feedback might occur when a weaker INR results in higher inflation, a higher current account deficit and consequently a new round of portfolio outflows, a weaker INR, etc.