Currency View. Further yuan devaluation, a key risk to rupee bl-premium-article-image

SHILPA KUMAR Updated - January 23, 2018 at 02:11 PM.

In a globally connected economy, the yuan depreciation will impact rupee movement

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The rupee has been on a gradual depreciation path, moving from around 59 in April 2014 to 64 levels by July 2015. This depreciation has happened despite the positive India growth story, which led to significant capital inflows through FY2015.

In fact, it was the RBI’s regular intervention that restricted the rupee appreciation and managed over-valuation concerns.

The economy continues to be relatively better placed compared to other emerging market economies. The business cycle has bottomed out and there are early signs of recovery. This is corroborated by the pick-up in industrial production data. Inflationary pressures have also eased and the RBI’s 6 per cent CPI goalpost by January 2016 appears manageable. There is scope for a 25 bps rate cut by the RBI in the September policy meeting. All of this is likely to continue to support sentiment and foreign capital inflows.

India’s external sector outlook has also improved dramatically, supported by low commodity prices. We expect CAD to narrow to 0.8 per cent of GDP in FY-16 as against 1.3 per cent of GDP in FY-15.  Hence, external vulnerability has moderated substantially. However, the sustainability of this improvement is still not clear as export growth has slowed down.

CAD less of a concern

 Financing the CAD is less of a challenge today than it was during the taper tantrum episode of 2013. The reliance on volatile capital flows such as FIIs and loans have reduced and FDI (a more stable flow) is sufficient to fund CAD. Even at this point of time, when portfolio flows are muted, FDI related flows remain strong at $10 billion in Q1 FY-16.

The RBI has played a key role in stabilising the rupee volatility. It has absorbed the strong capital flows last year, thereby building significant forex reserves of $354 billion. India’s import coverage has improved to around 11 months now from seven months during August 2013. 

This increases confidence in the economy and provides a cushion to address global shocks and limit significant depreciation pressure.  In summary, stable macro fundamentals and policy support are likely to support the currency. 

 Having said that, the rupee’s volatility has increased and its short-term trajectory would have to take into account various global developments such as the recent yuan devaluation. 

Since this devaluation on August 11, the yuan has depreciated by about 3 per cent. The motivation for the Chinese action was partly to align the currency to market forces and partly to support Chinese growth by boosting exports. This led to increased depreciation pressures on emerging market currencies.

Yuan devaluation

 Given India’s strong linkages to the global economy through trade and capital flows channels, the Chinese action can affect India’s balance of payment.

India’s trade deficit with China has increased manifold from $1.4 billion in FY-05 to $48.5 billion in FY-15. This is despite the rupee depreciating by about 88 per cent vis-à-vis the yuan.

Unilateral yuan devaluation is likely to increase India’s imports from China and further deterioration of trade deficit. This data suggests that India lags China on competitiveness parameters and, in the medium term, structural reforms are required to correct the imbalance. 

 The timing of the first rate hike by the Fed is another source of uncertainty for the financial markets. As a result, the dollar is likely to strengthen, thereby putting pressure on capital flows and emerging market currencies including the rupee.

 Overall, in the near term, we expect the rupee to trade in the 66-67.50 range. The key risk to the view is further yuan devaluation by China and any deviation from the expected rate tightening schedule of the Federal Reserve. While such global events could cause intermittent spikes beyond this range, we expect the RBI to keep volatility under check.

The writer is Senior General Manager and Head - Global Markets Group, ICICI Bank

Published on August 30, 2015 15:48