Fed effect vs Modi effect: the rupee-appreciation story
After the rupee’s spirited rally in line with the ascent of newly installed Indian prime minister Narendra Modi, analysts say rising US yields could undercut the currency, while others claim strong equity inflows and an improvement in the current account suggest appreciation for the rest of the year.
India, a former member of the fragile five, has seen a recent upsurge in investor interest.
Foreign investors have been pouring money into Indian assets and making plans to invest in onshore business ventures in anticipation that a new government led by Narendra Modi – who won a massive mandate on May 16 and formed a government on May 26 with his party, the Bharatiya Janata Party (BJP) – will kick-start stalled structural and economic reform in the country.
The rupee has been a notable beneficiary of this euphoria. From Rs68.5 to the $1 last summer – after the US Federal Reserve announced its intention to taper its asset purchase programmes, which hit emerging market (EM) currencies – the rupee has gained 17% to trade at Rs58.5 to the $1 in recent days.
Since mid-2013’s heightened volatility, the Reserve Bank of India (RBI) has been quietly reining in the currency and building up its stockpile of FX reserves since the new governor Raghuram Rajan took over in September.
The central bank’s efforts have been greatly buoyed by the “Modi effect”, which saw net inflows of capital in the country surge since he was announced prime ministerial candidate of the BJP in September 2013.
Most analysts, however, agree the rupee might have reached its peak and will trade around an equilibrium figure of Rs60 to Rs61 to the $1 in the near to medium term. The rupee is expected to face depreciation pressures in the next six-to-nine months as the dollar begins to strengthen in response to tapering and in anticipation of a rate hike by the Fed sometime next year.
Hamish Pepper, currency strategist at Barclays in Singapore, says the RBI has been able to build up FX reserves in the current environment, precisely because US yields haven’t risen yet.
“What’s allowing the RBI to accumulate dollars is that there is good news around the election and other sectors,” he says. “We are in an environment where the dollar is not strengthening and there is very low volatility across most asset classes, including foreign exchange.
“This will not last and an environment where US yields are rising won’t be as supportive for the carry trade and for EM assets.”
Barclays estimates the rupee to trade up to Rs60 to Rs61 to the $1 in the next three months.
The central bank’s FX reserves, a key metric that currency traders use to judge EM vulnerability to capital shocks, have gone up by $15.5 billion over FY 2013/2014. Net inflows from portfolio investments from October until April were $17 billion compared with a net investment outflow of more than $32 billion in the six months preceding October, according to figures from the RBI.
Indian equity markets are the main recipients of foreign portfolio inflows. The Sensex, Bombay Stock Exchange’s index of the 30 largest listed companies of the country, crossed its all-time high of 25,000 since May 16.
Rohini Malkani, economist at Citi in Mumbai, expects these to continue to increase, forecasting the rupee at 60.4 by the end of 2014.
“We expect greater portfolio inflows as most offshore investors are waiting for a stable government and a clear policy roadmap before they increase their portfolio weightage towards India,” she says.
Further, the RBI has made it clear it won’t be comfortable with a rupee stronger than current levels, according to Malkani.
The central bank has begun releasing monthly estimates of the currency’s real effective exchange rate (REER) based on consumer inflation figures – whereas it calculated the REER previously based on wholesale inflation figures – which Pepper at Barclays says indicate the currency is much closer to its equilibrium level than previously thought.
However, Craig Chan, head of FX strategy for Asia ex-Japan at Nomura, expects the rupee will perform strongly as the global economy recovers over the rest of the year.
“India is one place that should be a net beneficiary of global recovery,” he says. “It is very much a growth-driven economy and the currency should, therefore, stand out within the region as well.”
And despite the general consensus of a stable or slightly weaker rupee, Chan says the rupee might go up to Rs57 to the $1 by the end of 2014.
“If a country can structurally change and have reform in place for higher growth, then there is no reason why a currency that’s overvalued can’t move deeper into overvaluation territory,” he says. “Generally speaking, the capital inflow story can be a very powerful factor driving the currency.”
India’s current-account deficit (CAD) has also narrowed substantially during the past year, allowing the rupee to stabilize to its current levels. The RBI had put in restrictions on the import of gold in August, a key factor in reducing the CAD, says Malkani at Citi.
“The RBI and the previous government were able to reel in India’s current-account deficit from 4.7% of GDP to, we expect, close to 2% of GDP,” she says. “And this has happened before this new government took over.” (The RBI released official deficit figures after this interview of CAD at 1.7% of GDP for FY 2013/2014.)
On Thursday, the RBI relaxed some of the restrictions on the import of gold. However, Malkani says any impact on the CAD should be offset by decreasing coal imports due to an expected rise in coal mining and the potential lifting of a ban on exporting iron ore under the new government.