Rupee could weaken 68-69; Further depreciation risk remains

Of the three unexpected decisions by India's Monetary Policy Committee (MPC) at meetings since October 2016, the latest decision on 8 February, to change its stance to neutral from accommodative, was the most surprising. What surprised us most was that this change was announced even as the MPC seemed to have a relatively benign outlook for CPI inflation compared with December's policy meeting.

While the MPC did indicate that by switching its stance to neutral, it still has the flexibility to move the repo rate either way depending upon the evolving macroeconomic situation, we think the threshold for next rate cut is really high for two reasons. First, policy statements since 2008 show there are no instances of the RBI changing the repo rate while maintaining a neutral stance (barring black swan events like the global financial crisis or concerns around external-sector stability in 2013). Second, even before this policy meeting, the market consensus was that the rate-cutting cycle was close to an end (debate centred on whether the remaining rate cut would be 25 basis points(bps) or 50 bps). Therefore, it would be most unlikely for the MPC to shift back to an accommodative stance for a rate cut of only this magnitude.

Thus, the aggressive repricing higher in domestic yields and its support to currency did not come as a surprise. In the near term, further strength in the rupee cannot be ruled out, particularly, if domestic yields continue to move higher. However, we remain sceptical of sustained rupee strength. We maintain our view that the rupee is unlikely to be immune to broad US dollar strength. Given the Federal Reserve is expected to hike its rate five times between 2017 and 2018, US dollar strength and thus rupee weakness in next few months, is inevitable.

Also, the rupee remains overvalued. While the real effective exchange rate (Reer) at 118 exaggerates the strength (simplistic interpretation is that rupee is overvalued 18%), even after adjusting for base year and productivity differential rupee overvaluation by c.5% cannot be denied. Thus, we expect rupee to weaken at 68.75 by mid-2017 and 69 by end-2017, with risks skewed for further weakness.

The writer is head, South Asia Economic Research (India), Standard Chartered Bank, India