Where’s the rupee going?

In 2015, a slew of major global events — such as the oil price shock, global slowdown, worries on China and the US Federal Reserve beginning its rate hike cycle — made the dollar index surge 10 per cent higher. This sent emerging markets’ currencies reeling. The Russian rouble, South African rand and Brazilian real plummeted between 16 and 33 per cent against the dollar. However, the rupee remained an out-performer, losing just 5 per cent against the dollar.

 But 2016 has not been good for the rupee. The worst performing currencies of 2015 have turned out to be the best performers so far in 2016 whereas the rupee is a clear under-performer. It is down about 2 per cent (year-to-date) while other emerging currencies such as the real, rouble and rand have strengthened 20, 13 and 6 per cent, respectively, against the greenback over the same period.

 What is the reason for the rupee’s under-performance in 2016? We take a look at the factors responsible for dragging down the rupee, and also factors that will influence currency movement in the future.

Trade and deficit  Slowing merchandise exports have been one of the prime factors pegging the value of the rupee lower in recent times. The country’s export growth has been declining over the last 18 months (on a year-on-year basis). Exports are down 16 per cent from $26.49 billion in November 2014 to $22.17 billion in May 2016.

 The silver lining is that imports are also down in this period, thus helping improve the trade deficit. Imports plummeted 33 per cent from $42.72 billion in November 2014 to $28.4 billion in May 2016. The higher pace of fall in imports compared to the exports has helped in bringing down India’s trade deficit. This has been one of the major factors that helped limit the fall in the rupee in 2015. The trade balance has narrowed from a deficit of $16.2 billion to $6.3 billion over the last 18 months since November 2014.

Are exports stabilising?  After declining to $20.74 billion in February, the value of exports has risen to $22.17 in May. Some semblance of stability is currently visible with export figures between $20 and $23 billion, so far this year. Reversal in the price of crude oil and precious metals has been the major contributor to this up-tick. Petroleum products contribute about one-fifth (20 per cent) of the total exports while gems and jewellery contribute about 15 per cent.

The US and UAE are India’s top two export destinations. While exports to the US account for 14 per cent of total exports, UAE accounts for 11 per cent. On an average, about 25 per cent of the country’s total exports is to these countries. Thankfully, the US continues to grow at a steady pace unlike many other developed countries. The US Federal Reserve expects the US to grow at 2 per cent over the next two years.

The prospects of the UAE are, however, not as rosy, with the country hit hard by falling crude prices. The IMF expects growth in UAE to be the slowest pace since 2010 at 2.4 per cent in 2016. Given the mixed growth picture in these countries, a sudden and sharp reversal in exports appears unlikely.

The crude and gold factor  But, will the import bill continue to ease? The possibility is low, given the recent surge in crude oil and gold prices. Crude oil (Brent) prices had almost doubled from the multi-year low of $27 per barrel in February to a high of $53 in June. Similarly, gold prices bottomed at around $1,050 per ounce in late 2015 and have jumped 30 per cent since then to the current levels of $1,360.

The US Energy Information Administration (EIA) expects global oil production to increase at a slower pace of 0.52 and 0.81 per cent to 96 and 97 million barrels per day in 2016 and 2017, respectively, compared to a sharp 2.6 per cent increase in 2015. On the other hand, the demand is expected to increase at a constant rate of 1.5 per cent for the next two years to 95.3 and 96.7 million barrels per day. This is expected to bring down the surplus from about 2 million barrels per day in 2015 to 0.3 million barrels per day by 2017. A fall in surplus over the next two years suggests that the downside in oil prices could be limited and there is a possibility of oil inching higher.

 Gold, on the other hand, is surging, thanks to its safe haven status. The outcome of the UK referendum last month, to exit the European Union, had caused a serious sell-off in risky assets like non-dollar currencies, stocks, etc. This helped gold prices breach the psychological $1,300 mark last month. Also, the US Federal Reserve’s decision to go slow on hiking the interest rate (only one more rate hike is expected this year compared to four rate hikes anticipated earlier) can keep the dollar under check. These are positives for gold. As such, bullion prices are expected to stay on a strong wicket.

 Strength in crude oil and gold spells trouble for our trade deficit since oil and gold imports contribute about 40 per cent to the import bill. With exports not likely to revive significantly in the near future and value of imports likely to move higher, the trade deficit can expand again, pressuring the rupee.

Slowing foreign inflows Slowing inflows, both in the equity and the debt segments from Foreign Portfolio Investors (FPIs), is the other major drag on the rupee in 2016. Earlier, foreign funds invested mainly in equities and flows into debt segment were minimal. So there was a strong correlation between the Indian equity benchmark indices (Sensex and Nifty) and the rupee. But since 2011, flows into debt have increased significantly and the money flow into this segment has started to strongly influence the rupee movement.  

It may be recalled that the $13-billion debt outflow between June and November 2013 was the major factor that made the rupee plunge to its all-time low of 68.85 in August 2013. The inflows in the debt segment seem to be lagging this year, impacting the rupee. The debt segment has seen an outflow of $1.65 billion so far this year while equities have attracted an inflow of $3 billion. But if there is a global risk-off trade, Indian debt is likely to witness outflows as EM debt is among the most vulnerable asset classes.

Strong FPI outflow from equity market is, however, not likely, given the superior prospects of Indian equity market. The Indian economy, largely driven by domestic consumption with lower reliance on exports, is relatively insulated from external shocks. Foreign investors are, therefore, unlikely to stay away for long.

 The invisible deficit  Easing trade deficit has helped the current account deficit (CAD) to come down significantly from $32 billion in December 2012 to about just $0.3 billion deficit in March 2016. But if the trade deficit is going to widen because of the oil and gold prices, that will impact the CAD.

 Also, the invisibles, another major component in the CAD that includes services and transfers, have tumbled since December 2014. The invisible component has fallen 21 per cent from $30.86 billion in December 2014 to $24.42 billion in March 2016.

Software services and private transfers, which are the major sub-components, have been falling in recent times, thereby dragging down the invisibles. Software services (which had contributed $16 billion on an average over the last five years to the invisibles), dropped 6 per cent in the March 2016 quarter compared to the previous quarter. Nasscom has downgraded India’s IT services export growth to 10-12 per cent for the current fiscal year from 12-14 per cent projected earlier. So, a slowdown in Indian IT services might continue to drag the invisibles further lower.

Private transfers (which also contributed $16 billion on an average over the last five years to the invisibles), are down for two consecutive quarters by about 8 per cent since September 2015, from $16.3 billion to $15.1 billion. A CRISIL research report shows that remittances from the Gulf Council Countries (GCC) fell for the first time in six years by 2.2 per cent. GCC contributes more than half of the total remittances, according to the CRISIL report. The IMF has slashed the GCC growth outlook to 1.8 per cent for this year from 3.3 per cent growth in 2015, due to lower oil prices. Since falling invisibles can further widen the CAD, this component too needs a close watch.

Other factorsExternal debt : India’s short-term external debt coming down consistently over the last three years is a positive. Short-term debt is down 15 per cent from about $92 billion in June 2013 to $85 billion in December 2015. Though the long-term debt remains elevated, the pace of increase has slowed down since last year. India’s long-term debt remained around $399 billion all through last year.

Strong forex reserves : India seems to have learnt a lesson from the rout caused by the FPI outflow in 2013. The country is definitely in a better position today, to face such uncertainties. This is evident from the forex reserves built in recent years. From $275 billion in September 2013, the reserves have increased to $363 billion. These reserves can cover about 10 months of the country’s import, a comfortable number. Also, these reserves can be used as a tool to intervene in the currency market to arrest any unexpected event-related volatility.

Rupee overvalued : The Real Effective Exchange Rate (REER) of a currency is a measure of valuing a currency against the currencies of its trade partners after adjusting for inflation. A currency is considered to be overvalued if its REER is greater than 100 and undervalued if the REER is less than 100. The 36-currency trade weighted REER as of May was 110, which means the rupee is over-valued by 10 per cent.

Event risks : Certain events such as the expected redemption of $25 billion worth of Foreign Currency Non-Resident (FCNR) deposits between September and November could result in short-term volatility in the rupee. Another major event to watch in the coming months is the US elections in November.  Brexit will continue to create ripples in the currency market, once the exit is triggered and Britain begins the process of disengaging from the EU.

Summing up, stability in export growth, decline in short-term debt and strong forex reserve positions are positive for the rupee. However, the threat of the deficit widening due to an increase in oil and gold prices and the REER indicating an overvalued rupee are negatives. The fall in invisibles is another worry. With key global events yet to unfold, the upside in the rupee is expected to be capped. But that said, though there is room for the rupee to weaken in the coming months, the pace of currency weakening could be slow.

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