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Big Story | What lies ahead for the rupee?

Akhil Nallamuthu | Updated on August 12, 2020 Published on August 08, 2020

The factors favouring the Indian currency’s appreciation outweigh the negatives at this juncture

The rupee was quite stable in 2019, ending the year with a loss of 2.6 per cent, but 2020 has been quite eventful for the Indian currency.

The Covid-19 pandemic that has the world in a vice-like grip has had a debilitating effect on all economies, impacting currencies as well.

The rupee was largely stable in the beginning of 2020, moving between 70.5 and 72 against the dollar. This was the range that had shackled the Indian currency in 2019 as well.

 

Despite the slowing growth last year, the rupee was steady thanks to robust dollar inflows in the form of foreign direct investments (FDI), foreign portfolio flows and higher external corporate borrowings.

But the scales turned dramatically in March this year as financial markets hit the panic button, leading to large-scale selling in all asset classes. Currency markets were also hit in this risk-off trade, with the rupee crashing nearly 9 per cent from the January peak to hit a low of 76.91 in April.

Since then, the domestic unit has gradually recovered and is now hovering around 75, with the year-to-date loss at 5.1 per cent.

Going ahead, the fortunes of the rupee are tied closely with the spread of the pandemic and further stimulus infused by central banks. The impact this has on foreign portfolio flows and the dollar will be the main determinants of the rupee’s trajectory over the next year.

Easy monetary policies to the aid

Responding to Covid-19, central banks worldwide have been flooding their respective economies with massive stimulus funds.

For instance, the US Federal Reserve has announced liquidity injection of over $3 trillion so far, European Central Bank has launched stimulus measures amounting to €1.35 trillion ($1.6 trillion), Bank of Japan has committed over 110 trillion yen ($1.03 trillion) and Bank of England has announced asset purchases worth £745 billion ($975 billion).

At least a part of this huge dose of money is likely to find its way to the financial markets.

Empirical data show a strong link between central bank stimulus and stock price movement. This is because the expansionary monetary policy helps contain the damage to the economy, thus helping corporate earnings and stocks. Also, rock-bottom interest rates leads to carry-trades with loans being taken in countries with zero or negative interest rates to invest in riskier assets such as emerging markets.

Being one of the largest emerging economies, this money supply is expected to chase financial assets in India, too. This is already being witnessed in the increased inflows by way of foreign portfolio investments in the recent months, particularly in the equities market.

As incoming dollars are converted to rupees, the demand for the domestic currency gets a boost.

Most of the central banks intend to pursue the stimulus measures as long as it takes; a few central banks have already announced extensions. Going by the Fed’s latest decision to stretch the facilities through December 2020, the monetary infusion is likely to be prolonged at least till mid-2021. Until then, the upward pressure on the rupee backed by foreign flows is likely to continue.

Dollar’s decline strengthens rupee

Another factor that rupee-watchers need to track closely is the movement of the dollar. It’s the weakness in the greenback that has been buttressing the rupee in recent months, due to the inverse correlation between the two.

The search for a safe haven drove the dollar higher in March, when the SARS-CoV-2 outbreak was labelled a pandemic. As dollar demand surged that month, the dollar index — a measure of the value of the greenback relative to a basket of currencies — rallied sharply and registered a fresh three-year high of 102.99.

But once the magnitude of the pandemic became apparent and the Fed decided to throw the kitchen sink at the economy, the dollar could not hold its ground.

The Fed’s asset purchases and loans at an unprecedented scale impacted the dollar in two ways. On one hand, it resulted in increasing the supply of the dollar, and on the other hand, it improved the risk sentiment, lowering the appetite for safety.

Also, the interest-rate advantage of the dollar over other major currencies such as the euro and the yen have now diminished following the aggressive rate cut by the Fed.

This led to a depreciation in the dollar index — it dwindled by about 10 per cent to 92.5, between March 20 and July 31, 2020.

As the Fed looks set to continue pumping in easy money at least till December 2020, there can be a consistent downward pressure on the USD till the end of the year. Consequently, the dollar index might move towards a five-year low at 88.25. Any extension or expansion of the stimulus measures can also expose the dollar to more downside, thus helping the rupee.

Mixed picture on foreign flows

Following a strong 2019, when foreign portfolio investors (FPIs) poured in $19.4 billion (equity and debt combined), FPIs have remained net sellers in 2020 with a net outflow of $13.5 billion till the end of July, thanks to an extensive outflow of $15.9 billion in March alone.

The equities and debt segments were equally hit in March with outflows of $8.35 billion and $8.1 billion, respectively. However, as the Indian stock market recovered and central banks began pumping liquidity into the system, FPIs turned net buyers in Indian equities after March. Their net purchases since April in equities amount to $4.9 billion.

These flows can, however, turn erratic if volatility resurfaces in equity markets.

 

FPIs remain net sellers in Indian debt, pulling out $5.2 billion since the beginning of April. The reduction of about 155 bps in Indian interest rates since March, coupled with high inflation, seems to have rendered Indian debt unattractive to foreign investors.

Net FDI inflows, a more durable form of foreign capital, was up 40 per cent to $43 billion in FY20. But FY21 can turn out to be tepid because of the Covid-19 onslaught. The United Nations Conference on Trade and Development (UNCTAD) expects global FDI to drop by 40 per cent in 2020 and by 5-10 per cent in 2021, thus impacting FDI flows into India as well. This can negatively impact the rupee as FDI was the major contributor to the rupee’s strength last year.

Flows through external commercial borrowing (ECB) by Indian corporates have also been strong in recent times ever since the RBI announced a framework in January 2019 that broadened the pool of eligible borrowers.

Also, the very low external interest-rate regime helps corporates raise fund at comparatively lower rates.

ECB flows were hit by the pandemic. While the inflows in January-March 2020 was $19.29 billion, it declined to $3.5 billion — a 11-quarter low — in April-June 2020. However, going ahead, as the global interest-rate environment is expected to stay low in the perceivable future, corporates are expected to continue to depend on ECB as a source of fund-raising, and these flows can continue to support the rupee until the spread of borrowing rates across India and other countries narrows.

 

Narrowing trade deficit

India’s current account deficit (CAD) more than halved in FY20 to $24.6 billion as trade deficit narrowed (because imports fell faster than exports) by $22.8 billion to $157.5 billion and invisible receipts increased by $9.8 billion to $132.9 billion. The drop in CAD has helped the rupee stay afloat. Trade deficit continues to narrows even into FY21 — it significantly contracted to $9.1 billion in the first quarter of FY21 against $45.9 billion in the corresponding period last year.

 

According to the International Monetary Fund (IMF), world trade volume is projected to de-grow by 11.9 per cent in 2020 and grow by 8 per cent in 2021. Considering this, trade deficit is expected to shrink further, which is conducive for the Indian currency.

Crude oil is the biggest import component of India and therefore its price has an inverse relationship with the rupee. Because of the collapse in the Brent crude price, the import bill tumbled 66 per cent from $9.5 billion in January to $3.2 billion in June. Crude prices declined from $66 a barrel in January to as low as $16 in April before recovering to $45 by July-end. These circumstances played out in favour of the rupee.

 

Based on a forecast by the US Energy Information Administration (EIA), excess production capacity and high inventory levels are expected to limit price increase of crude in 2020. The price can possibly increase in 2021 once inventory levels decrease and demand normalises. The forecast average price of $37.5 in 2020 and $45.7 in 2021 is still considerably low, much to the benefit of the rupee.

Robust foreign reserves

Strong dollar inflows on account of record FDI investments, FPI inflows and external borrowing of Indian companies have led to a $59.5-billion increase in forex reserves in FY2019-20.

It has already swelled by $56.8 billion to a record $534.6 billion for the current fiscal, significantly improving India’s position with respect to external obligations.

For instance, the current level of reserves can comfortably cover 13.4 months of imports, and the short-term debt (residual maturity) stands at 49.5 per cent of the total reserves.

These metrics indicate India’s strong reserve position, which is a big plus for the rupee. Also, FX reserves is an effective tool in controlling wild swings in exchange rate.

 

Looking ahead

The IMF has slashed the global growth rate for 2020 and 2021, and forecasts the global trade volume to tumble. Likewise, UNCTAD projects a sharp dip in FDI, which has been the largest contributor of inflows to India. However, it might not be all bad news for the rupee.

While the slowdown can hit exports, low prices of crude oil can help stabilise India’s current account balance. Similarly, the ultra-loose monetary policy and monetary stimulus announced by the central banks can result in more inflows into domestic financial markets in the coming months.

And, though there could be a temporary dip in ECB, the corporates are expected to continue to tap foreign loans as rates are cheaper. The downward pressure on the US dollar is also favourable to the rupee.

However, even with substantial inflows, the RBI might not be willing to let the rupee appreciate, as has been the case in recent times.

The reserve bank seems to be redirecting incoming dollars to foreign exchange reserves, which, as a result, has increased to historic highs.

While doing this, the central bank is able to inject rupee liquidity into the system as well as contain the Indian currency from appreciating sharply so as to maintain competitiveness in the global market.

With increasing reserves, the RBI has enough ammunition at its disposal to contain a potential downside as well.

Therefore, the factors favouring rupee appreciation outweigh the negatives at this juncture. However, the RBI’s actions are likely to limit the upside.

The RBI might want the exchange rate to be stable in a range and that makes us believe that USDINR may trade between 74 and 77 over the next year.

Rupee to remain range-bound

After marking an all-time low of 74.48 in October 2018, the rupee gradually recovered and largely traced a sideways path in 2019, ending the year with a loss of 2.6 per cent.

But the bears came haunting the rupee back in March 2020, bolstered by the Covid-19 pandemic. As selling pressure mounted, the rupee depreciated sharply and marked a fresh lifetime low of 76.91 towards April-end.

 

Major trend

Just before the global financial crisis in 2008, the domestic currency witnessed its best performance. Between January 2002 and December 2007, it appreciated by nearly 20 per cent, from 49.1 (its 2002 low) to 39.7 (its 2007 peak).

But the trend reversed and the rupee declined to 52.1 — a fresh lifetime low then — by March 2009, losing 31 per cent from its prior peak. Subsequently, there was a corrective rally.

However, the bears took charge again in 2011 and ever since, the Indian unit has been continuously forming lower lows. Thus, the major bear trend which began in 2008 seems to be continuing as the Indian currency recorded its new low — 76.91 — in April 2020.

Dollar index

The dollar index, which ended 2019 on a flat note, has looked more volatile since the beginning of this year. In March, it witnessed a sharp rally and marked a new three-year high of 102.99 on the back of safe-haven demand.

But the trend reversed abruptly as dollar supply increased and the index tumbled to form a fresh two-year low of 92.53 last week.

Going forward, even though there might be corrective rallies, the trend remains bearish, and so the index is likely to head lower to 89. A fall below this level can mount significant selling pressure on the dollar, possibly dragging it to 85.

Outlook

Even though the major trend of the rupee is downward against the greenback, over the short to medium term, it can chart a different path. As we can notice, the rupee recently firmed up from its lifetime low and has been tracing a sideways trend.

Going ahead, despite favourable conditions such as a weak dollar, the rupee is likely to stay flat for the next one year, possibly between 74 levels — the 38.2 per cent Fibonacci retracement level of the previous downtrend — and 77.

The Indian currency is likely to align with the major trend in the long term, and can even gradually weaken towards 80.

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Published on August 08, 2020
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