INR: Brace for more volatility

August 2018 was marked by significant volatility in the global currency markets. Contagion related to the crisis in Turkey seeped into other emerging market currencies. This caused the Indian Rupee (INR) to depreciate as well, and test fresh all-time lows.

While macro-economic troubles were anyway brewing in Turkey, sanctions imposed by the US on imports of metals from that country precipitated a sharp slide in the Lira, which depreciated relative to the US$ by 33% in August 2018 alone, and by a massive 67% since the beginning of FY2019 (till September 3, 2018).

The risk aversion triggered by the Turkish concerns crept into other emerging market currencies such as the South African Rand, Russian Rouble and Brazilian Real, which have depreciated by around 8-11% relative to the US$ in August 2018.

Other emerging market currencies, such as the Chinese Yuan, Philippine Peso, Mexican Peso, Malaysian Ringgit, Indonesian Rupiah and the INR, recorded a decline of up to 4% against the US$ in August 2018, amid a larger depreciation of 2-10% in FY2019 to date. Within this set of countries, the INR has been one of the weaker performers. It had already depreciated by over 5% in the first four months of FY2019, driven by the concerns regarding global trade wars and the weakness in the yuan, a year-on-year (YoY) rise in crude oil prices and foreign portfolio investors’ (FPIs’) outflows from the Indian markets. Subsequently, it depreciated relative to the US$ by a further 3.6% in August 2018, and recorded a fresh all-time low of 71.75/US$ (RBI reference rate) on September 5, 2018.

The Reserve Bank of India (RBI) intervention has helped to ease the volatility in the INR. FY2019 had commenced on a positive note, with an uptick in the Indian foreign exchange reserves to an all-time high in April 2018. This was followed by a slide, led by the RBI’s net intervention in the spot market to the extent of US$14.4 billion in Q1 FY2019. Notably, the size of this intervention rivals the sale of US$14.3 billion that the RBI had undertaken during May-September 2013, amid the taper tantrum.

Intervention is likely to have continued until mid-August 2018, given the further dip in the foreign exchange reserves. Moreover, the repo rate hike in August 2018 helped to revive the FPIs’ appetite for Indian debt, which was expected to stabilise the INR. Nevertheless, the global trends, risk-off sentiment and rebound in crude oil prices have resulted in a ~4% depreciation of the INR relative to the US$ so far in Q2 FY2019.

Since most emerging market currencies are recording some depreciation, the rupee must weaken to protect the competitiveness of its exports. At the same time, with the extent of the INR weakness only modestly larger than many of the other emerging market currencies, it is unlikely to appreciably improve the volume growth of Indian exports.

Looking ahead, risk sentiment, dollar strength, broader emerging market currency movement, the trend in crude oil prices and the RBI’s actions will drive the outlook for the INR.

The expectation of continued monetary tightening by the US Federal Reserve, and intermittent flaring up of concerns related to geopolitical tensions and trade wars may prolong the risk-off sentiment, which would maintain the secular strength of the US$ in the rest of this calendar year. However, questions regarding the sustainability of US economic growth over the medium term may dampen the dollar rally going forward.

Crude oil prices continue to display a volatile trend, driven by geopolitical risks and the balance of global demand-supply conditions and inventories. Since India is one of the larger oil importers in the emerging market pack, the trend in crude oil prices tends to negatively affect many macro fundamentals, including the outlook for inflation, the twin deficits and economic growth, and rapidly transmits into the rupee and bond yields.

An expected dip in the August 2018 CPI inflation below the Monetary Policy Committee’s (MPC’s) medium-term target of 4.0%, juxtaposed by the looming inflation risks, the robust GDP growth print for Q1 FY2019 and the continued weakening of the INR, would complicate the upcoming monetary policy decision. This would have an impact on the sentiment toward the INR, which would in turn influence the FPIs’ decision to enter the Indian debt market, following the mild revival in inflows that was seen in August 2018.

Other domestic factors that would influence the trend in FPI investments as well as the INR, include the momentum of domestic economic growth, as well as concerns regarding the twin deficits.

Despite the intervention, India’s foreign exchange reserves remain sizable at around 10 months of FY2018 merchandise imports. Moreover, its external debt metrics remain moderate, offsetting some of the concerns posed by the likely rise in India’s current account deficit to 2.8% of GDP in FY2019 from 1.9% of GDP in FY2018. Overall, we anticipate that the RBI is likely to assess the trend in the INR vis-à-vis other emerging market currencies, to determine the extent to which it should intervene to reduce the volatility in the currency.

Given the prevailing risk aversion in the global markets, the rupee may weaken to 72-73/USD before retracing to an extent, especially if crude oil prices ease from the current levels. The cross rate is expected to display two-way volatility going ahead, and average Rs. 68.5/USD in FY2019. Indian Corporates that are unhedged may be in for testing times, especially if they have a substantial volume of external debt to be serviced in the next year.

The writer is the Principal Economist, ICRA. Views are personal.