The Indian Rupee (INR) reached a record low against the US Dollar in August 2013, slumping over 20% as investor confidence in economic management plummeted. The Rupee has since rebounded on a combination of economic optimism and a renewed commitment to fighting inflation by the central bank under a new governor. We expect that this rebound will gather momentum in 2014 as fundamentals continue to improve. We expect INR/USD to trade back towards55, as foreign investment flows begin to gradually return and liquidity concerns surrounding the start of US Fed tapering of its US bond purchasing program are in the rear view mirror.
Capital Outflows
While most developed countries would welcome India’s real economic growth of 4.4% in Q2, this represents quite a slowdown from the heady 9-11% growth rates the country was experiencing three years ago. The slowdown in growth together with a large current account deficit and rising inflation has not been a good combination for the Rupee.
Outflows of short term capital from India sparked the initial slump of the Rupee. Investors fled the currency, pushing it to a record low of nearly 69 against the USD in August. The central bank instigated emergency measures in July, raising interest rates to counter fund outflows and help stabilise the Rupee’s plunge. The central bank also set up two swap programs which allow banks that attract foreign funding to swap those funds for Rupees at a lower rate than prevailing market rates. The intention is to attract foreign funding and reduce the external financial burden.
The central bank has now extended the programs and so far they have attracted US$22.7 billion, an amount equivalent to the current account deficit, helping bolster the external financing position. Since the new measures have been put in place, the Rupee has rallied by 10 % to around 63 per USD. With the stabilisation of the currency and the inflow of investor funds, the RBI has begun to normalise policy by reducing emergency rates back to historically defined targets.
Current Account Issues
The outflow of funds coupled with negative real interest rates has seen India’s savings gap widen. The current account deficit is now hovering around a record 5.3% of GDP. The Indian government introduced restrictions on gold imports this year, which, along with energy imports, are the major contributors to the deficit. The government imposed import curbs appear to be having an impact with the current account deficit recently showing signs of stabilising. The Reserve Bank of India anticipates the deficit to fall to 3% of GDP in 2013.
The modest improvement in the current account deficit has largely been the result of better trade figures. The trade deficit reached a 30 month low in September before widening in October, primarily the result of festival-induced gold demand. Despite this, gold and silver imports are down 80% on year ago levels. The Rupee should also benefit indirectly from falling oil prices given the fact that oil refiners financing crude oil imports are the largest buyers of foreign currency. Alongside the improvement in import performance, exports have grown for four consecutive months.
Mitigating Factors
Ratings agency Standard & Poor’s have recently noted the potential for a credit rating downgrade if the policy agenda of the newly elected government in early 2014 isn’t sufficient to generate better growth prospects and turn the government’s fiscal deficit around. From the government perspective, there has been some progress, with the Indian budget deficit totalling 5.8% of GDP, down from over 7% of GDP in late 2011.
External debt levels have almost doubled over the past five years with the majority denominated in US dollars. The fall in the Rupee has therefore increased the servicing costs. However, the amount of Indian Rupee debt as a proportion of total external debt has fallen from around 15% to 25% over the same period.
A key indicator that signals the potential for an external crisis, is the ratio of reserves to external debt. According to the Indian government, the ratio has fallen from 109% in 2005/2006 to around 75% in 2012/13. While the decline in reserve cover is negative, there are mitigating factors and the situation is improving. A large part of the increase in external debt has resulted from a rise in shorter-term debt related to trade credits.
With imports being restricted by government regulations, this debt should fall. Additionally, the Indian government’s share of total debt is less than a quarter, with the bulk of borrowings coming from bilateral and multilateral sources which tend to be more stable and have long maturities.
The greater level of market confidence is being prompted by the central banks’ recent actions and its more clearly communicated policy stance. Under the new governor Rajan, the central bank also appears more committed to reducing inflationary pressures, lifting interest rates twice since September. Inflation is a persistent issue in India, exacerbated by surging food and fuel costs.
A near 20% rise in food and over 10% increase in fuel costs led to a 7% annual rise in prices in October from 6.5% a month earlier. Rising interest rates should help mitigate the poor saving environment by quelling inflation and thus raising real rates. More committed central bank policy will be conducive to structural confidence in the Indian Rupee.
Conclusion
While we are optimistic on the outlook for the Rupee on a six to twelve month view, we expect some near-term headwinds. As theexpectation of US Federal Reserve bond buying tapering is increasingly priced in during Q1 2014, USD/ INR could soften. Q1 2014performance of USDINR will also depend on the result of the Indian elections. Provided Indian politicians deliver real economic reform, we expect Q2 2014 to be the beginning of longer term structural appreciation for the Rupee toward levels of 55 per USD.