INR outlook: On a stronger footing

  • We expect INR to trade in a range of 60-62 during FY2015.
  • Compression in current account deficit (CAD) and accretion to foreign exchange reserves amid policy induced capital inflows helped reduce the external sector vulnerability.
  • The key risk to the outlook is the outcome of the general election in May’2014 and shift in Fed’s monetary policy stance from gradual to aggressive tapering


The Indian Rupee has witnessed remarkable stability in the recent weeks, trading in the range of 60 - 62. The extreme volatility in INR has reduced considerably over the last few months. Our analysis suggests that realized volatility for USDINR cross has fallen by around 80% compared to the peak
volatility in September 2013. In the immediate near term the upcoming general elections are likely to in crease volatility in the Rupee.

 

Federal Reserve errs on the side of caution


In the recent FOMC policy meeting, Fed offset its dovish stance of removing the unemployment rate target of 6.5% as an anchor for interest rate increases by hawkish expectation of a higher policy rate of 1.0% by end-2015 (vs. 0.75% prior).Though we believe that US interest rates are likely to go higher in the medium term, the movement is likely to be gradual.Consensus expects US Treasury 10 year yield at 3.34% by Q4 2014 vs.
2.74% presently. Amid this gradual move in US rates, we believe that risk assets are likely to remain supported and the contagion from higher US rates to depreciation pressure on EM
currency (including INR) has reduced considerably.


Reduction in external sector vulnerability aided capital inflows


Sharp compression in current account deficit (CAD) led by lower gold and other imports and accretion to foreign exchange reserves amid robust capital inflows helped in improving th
e medium term dynamics for India.The reduced external sector vulnerabil ity has aided capital flows to India.Net FII flows have turned positive in Jan-March 2014 with an inflow of USD
8.4 bn vs. an outflow of USD 5.3 bn in April-December 2013.


Outlook: Rupee to trade within a range of 60-62 for FY2015


We continue to believe that INR will trade in the range of 60-62 through the course of FY2015, though intermittent spikes beyond the range cannot be ruled out. Formation of a stable government will bouy capital flows thereby aiding appreciation pressure on the Rupee. However we believe that the
Central Bank is unlikely to allow for very sharp appreciation in Rupee.

INR outlook: On a stronger footing

INR witnessed remarkable stability in recent times

INR outlook: On a stronger footing

The Indian Rupee has witnessed remarkab le stability in the recent weeks, trading in the broad range of 60 - 62. In Q1’FY2014, the sharp depreciation in Argentina peso, aggressive policy rate hike by Turkey and the recent standoff between Russia and Ukraine, reignited the fears of another bout of volatility in the EM currency space. However, IN R outperformed the vulnerable EM currencies. In the subsequent section we delve into international and domestic developments and their implications for INR.

Fed guidance support gradual rise in US rates

Federal Reserve errs on the side of caution


The US Fed dropped the unemployment rate target of 6.5% as an anchor for interest rate increases and shifted to a qualitative form of forward guidance. The Fed members believe that unemployme nt rate is too limited an indicator of the labour market's health and there is still ample slack in the economy. We think that the shift from a rigid quanti tative assessment to a more flexible qualitative assessment of economic activity is an indication of a dovish stance by the Fed. However, this dovish stance was offset by Fed’s hawkish communication which suggested an earlier than envisaged exit path. The Fed’s projection suggested that participants now expect a higher policy rate at end-2015 and 2016 relative as compared to their December projections. A majority of the Fed members have revised their Fed Funds rate target for end 2015 and 2016 to 1.0% and 2.25% respectively, a notch above their December expectations. At the current pace of tapering of USD 10 billion at each meeting, this would imply a first rate hike in Q2’2015.

Correlation of US rates with INR has weakened

Gradual shift in Fed policy st ance is positive for INR


We believe that US interest rates are likel y to go higher in the medium to long term, the movement is likely to be gr adual. Amid the gradual move in US rates, we believe that ri sk assets in general will remain supported.

The contagion from higher US yields to risk assets (including INR) has reduced considerably in the post taper wo rld. On this basis, INR is likely to face less depreciation pressure as compared to other EM currencies.

Despite EM volatility Rupee remain stable in Q1

The volatility in the Rupee has reduced significantly


Despite brief episodes of volatility in the EM markets in Q1, the INR has remained stable. Our analysis suggests th at 30 day rolling realized volatility for USDINR cross has corrected by around 80% compared to the peak volatility of September-2013 (as measured by the standard deviation). Since September’2013, USDINR realized volatility has remained lower than the average realized volatility for the stressed EM currencies.

Reduction in external sector vulnerability supported the Rupee


INR outperformance vis-à-vis other EM currencies and reduced realized volatility majorly reflect the sharp improvement in external sector outlook. Sharp compression in CAD led by lower gold and other imports and accretion to foreign exchange reserves amid ro bust inflows in the form of banking capital and NRI deposits helped in impr oving the medium term dynamics for India. Additionally, the reliance on vo latile capital flows has diminished and financing through stable sources of capi tal (i.e. FDI and Loans) is enough to bridge the CAD in FY2015.

Stable capital sources enough to finance the CAD

Benign global market condition s upports capital flows to India


The global financial markets have taken the gradual QE tapering program by the Fed in it’s stride and market impa ct has largely been muted. The Fed has been successful in mitigating the adverse impact of tapering on market volatility by effectively communicating its stance of a mild taper and dovish forward guidance.

 

After witnessing an outflow of USD 5.3 bn in April-December period, net FII flows have turned positive in Q1 with a net in flow of USD 8.4 bn. As a result, India witnessed capital inflows of USD 3.1 bn on a FYTD basis. Component wise, debt related outflows were USD6.5 bn while equities witnessed an inflow of USD9.6 bn.

FII inflows improved amidst benign global market conditions

Events in the horizon


Though the external sector vulnerability has reduced considerably, it is not to say that risks have been completely eliminated . In our view, the key risk to the outlook includes:-

Outcome of general election key event risk

General election outcome: The outcome of the general elections will be a key input to maintaining the recent gains in the Indian currency. Formation of a stable coalition will help in expediting the reform process, support growth and will result in foreign capital inflows. This is likel y to support appreciation bias for the currency. Any other outcome will be negati vely perceived by the market and will result in depreciation pressure on INR. Th e volatility in Rupee is likely to increase in the runup to the upcoming general elections. To recap, in the last three general elections of 1999, 2004 and 2009, when stable government was formed, Rupee has appreciated by 0.4%, 0.3% and 3.3% respectively.

Shift in Fed policy stance to weigh on INR

Fed shift to an aggressive monetary policy stance: Any shift in Fed policy stance from dovish to hawkish backed by improving macro economic conditions will create volatility in the global financial markets and will have implication for INR.

NR to trade within a range of 60-62 for FY2015

Outlook: We expect INR to trade within a range of 60-62 for FY2015


We continue to believe that INR will trade in the range of 60-62 through the course of FY2015, though intermittent spikes be yond the range cannot be ruled out. The formation of a stable government at the centre is likely to bouy capital flows thereby aiding appreciation pressure on the Rupee. However, we believe that the Central Bank is unlikely to let the Rupee to appreciate very sharply in order to support recovery in exports and partly to replenish its reserves to increase FX import cover. From a long term perspective, lower CAD aided by higher exports growth rather than compression in imports, will be crucial to sustain the recovery in Rupee.