Indian Rupee: Defying Gravity. But, For How Long?

We don’t think this equilibrium sustains & look for USD/INR to break 80 within the next couple of months, writes UBS’ Rohit Arora.

<div class="paragraphs"><p>Photo: Rupixen/Unsplash</p></div>
Photo: Rupixen/Unsplash

Indian assets’ inverse correlation with commodity prices goes back years. Yet, since the onset of the Russia-Ukraine war—when Bloomberg’s commodities index gained 16%—the Indian Rupee is broadly unchanged on a trade-weighted basis. Not only that, the rupee carries the second-lowest uncertainty premia (i.e. 3-month implied volatility from the options markets) across major emerging forex markets, lagging behind only the pegged Hong Kong Dollar.

That’s a pretty impressive performance and market confidence, in the context of elevated oil and coal prices, problematic current account balance (which was deteriorating even before the war), record equity outflows (of $21 billion year-to-date and counting), and a record high Wholesale Price Index inflation of 15% year-on-year. Seems too ‘smooth’ to be true. We don’t think this equilibrium sustains and look for the USD/INR to break 80 within the next couple of months.

Three Depreciation Forces Underway

1. Deep current account deficit

We think India’s current account deficit in the financial year 2022-23 will likely deteriorate to at least 3% of GDP. This means the Indian financial system would need about $100 billion of foreign portfolio or direct investment inflows to prevent the rupee’s exchange rate from depreciating. Otherwise, rupee valuations should adjust to a level that stabilises the exchange rate market’s demand-supply imbalances.

As a reference, UBS estimates that India’s sustainable current account deficit stands at about 2% of GDP; any slippage beyond that should lead to a depreciation of the currency.

Indeed, the rupee’s worst depreciation in recent history occurred either when the deficit rose a long way above the 2% threshold (i.e. in 2011-2013 or during two quarters of 2018, when the currency lost on average 10% per annum), or during global financial markets shock (second half of 2008, the first quarter of 2020).

Today, the first condition is certainly in place and ongoing global financial conditions tightening could also offer some shades of the latter. Given these conditions, can the rupee keep defying gravity?

2. Look for newer records on foreign equity outflows

Year-to-date outflows of $21 billion from India’s equity markets do not necessarily mean that the scope for selling has reduced. Despite this intense foreign selling, Indian equities still seem expensive relative to other emerging markets, and versus the Indian government bond yield. Indian equity benchmarks have outperformed regional/global benchmarks by 10%-11% YTD, while MSCI India’s 12-month forward earnings yield sits 2.2% below the 10-year government bond yield (Note: This spread is currently at the 13th percentile of its 10-year history, according to our estimates).

The longer household flows keep equity market valuations elevated, the greater the scope for non-resident outflows.

South Korea’s unprecedented equity portfolio outflows in 2021 might offer a good case in point.

3. A steep deterioration in terms of trade

India’s terms of trade—the unit exports price vs. unit imports price ratio—have fallen to all-time lows. While the Russia-Ukraine war has played a role in this deterioration, it has been an ongoing trend since 2021. Despite this extremity, the rupee’s real effective exchange rate is sitting close to 10-year highs (or 4.2 standard deviations above the mean). We don’t think this is sustainable.

Given all of that, why is the rupee currently trading so strongly?

Most market participants are aware that the rupee’s stability has been partially driven by the Reserve Bank of India’s forex smoothening. That is understandable in the context of the central bank’s historically low tolerance for rupee volatility. But when this volatility declines—as it has during the past couple of weeks—could this smoothening take a back seat? We think so. After all, if exchange rate volatility has its side effects so does sustained exchange rate appreciation. The latter, if sustained, risks hurting export competitiveness and could marginally undermine the authorities’ vision to generate growth in India’s manufacturing sector.

Rohit Arora is Asia FI/FX Strategist, at UBS Global Research.

The views expressed here are those of the author, and do not necessarily represent the views of BQ Prime or its editorial team.