Unwinding of carry trades, FPI outflows leave rupee lagging other Asian currencies

At the start of 2020, the rupee was one of the best performing Asian currencies. But the wave of global risk aversion, following the Covid-19 epidemic, has reversed the fortunes of the domestic unit.

The currency’s weakness over the past two weeks has been despite weak crude oil prices and a declining US dollar. The rupee typically has an inverse relationship with these two factors. Heightened global risk-aversion that is leading to unwinding of speculative positions (mainly carry trades) in rupee, and foreign portfolio outflows seem to be behind this atypical behaviour of the rupee.

The rupee was quite stable between January 1 and February 21, losing just 0.37 per cent against the greenback. Other Asian currencies such as the Japanese yen, Singapore dollar, South Korean won and the Thai baht, had lost over 2.5 per cent against the dollar in this period, in the initial phase of the Covid-19 scare.

But as the number of infections outside China started to rise over the last two weeks, there has been a sharp sell-off in the rupee, with the currency losing 2.91 per cent against the dollar. On the other hand, other Asian currencies, with the exception of the Indonesian rupiah, have gained against the dollar.

Carry trades unwind

One of the main reasons for the rupee’s recent weakness appears to be unwinding of carry trade positions in the rupee. Carry trades are positions built in various asset classes across the globe with the help of money borrowed in currencies with extremely low or negative interest rates.

“Rupee had become a favourite currency for carry trade due to low volatility in 2019,” says Anindya Banerjee, Deputy Vice- President of research in currency and interest rates, Kotak Securities. “The higher interest rate differential between India and other countries helped. While inflation risk was present, it was expected to fade away by the end of this year. Because of this, significant dollar short positions were built not only onshore, but also in the offshore market.”

The decline over the past couple of weeks resulted in deterioration in carry return, which might have prompted a liquidation of such positions, according to experts.

Also, expectation of a rate cut by the RBI may be hurting the rupee. “The US Federal Reserve has already done a 50-bps rate cut last week and a lot of other central banks are expected to follow suit as everyone wants to support their respective economies”, says Rahul Gupta, Head of Research, Currency, Emkay Global Financial Services Ltd.

Such an expectation should be discouraging for carry positions because a rate cut can bring down the interest rate differential. So, just as carry trades aided rupee’s outperformance, the exits have been contributing to the relative underperformance.

FPI pulls out

The Indian equity and debt market, on the back of the global downtrend, witnessed foreign portfolio outflows over the last few weeks, weighing on the rupee. As on Friday, net FPI outflow (equity and debt combined) for the month was ₹13,138 crore, according to the latest data by National Securities Depository Limited (NSDL). Net investments for the calendar year have thus become negative (minus ₹3,211 crore). By February-end, there were net inflows of ₹9,927 crore. In contrast, FPIs had pumped in ₹1.36 lakh crore in 2019, which had helped the rupee stay afloat last year.

While the external balance, interest rates and fundamentals of the economy impact the long-term trajectory of the rupee, FPI flows have greater influence over short-term rupee movement.

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