Disclaimer: Although I am very interested in currencies, FX is the asset class in which I have the thinnest track record in making any directional predictions, commentary, and trading strategy. Comments below are meant for discussion only, are made without referrence to a Bloomberg terminal or other easy data provider, and should not be relied on for investment or risk management purposes.
At least five times since my arrival in India last week, I have been asked for my thoughts on the big decline in the Indian rupee this year and my outlook for the currency over the next year or two. From the current USD/INR level of around 64, I would draw a broad mid-term range of 60-72, based back-of-the-envelope on two fundamental factors (inflation and RBI policy) and four market factors (momentum, carry, EM sentiment, and the dollar), marked below in bold.
Inflation seems to be an obvious culprit “on the ground” as much as in the official statistics. As excited as I was about coming to India this year with my strong dollars, several goods and services here are noticeably more expensive than last year and multiples more expensive than just a few years ago. The IMF forecasts Indian inflation over the next two years being even higher than in Vietnam or Pakistan:
Inflation Rates in select emerging markets
| Country | 2008 | 2009 | 2010 | 2011 | 2012 | 2013 | 2014 |
| Brazil | 5.7 | 4.9 | 5.0 | 6.6 | 5.4 | 6.1 | 4.7 |
| China | 5.9 | -0.7 | 3.3 | 5.4 | 2.7 | 3.0 | 3.0 |
| India | 8.3 | 10.9 | 12.0 | 8.9 | 9.3 | 10.8 | 10.7 |
| Indonesia | 9.8 | 4.8 | 5.1 | 5.4 | 4.3 | 5.6 | 5.6 |
| Pakistan | 10.8 | 17.6 | 10.1 | 13.7 | 11.0 | 8.2 | 9.5 |
| South Africa | 11.5 | 7.1 | 4.3 | 5.0 | 5.7 | 5.8 | 5.5 |
| Turkey | 10.4 | 6.3 | 8.6 | 6.5 | 8.9 | 6.6 | 5.3 |
| Vietnam | 23.1 | 6.7 | 9.2 | 18.7 | 9.1 | 8.8 | 8.0 |
[Source: IMF WEO database]
Paired with the slowdown in Indian growth since 2011, the problem of “too many rupees chasing too few goods” at double-digit rates easily makes room for another double-digit weakening of USD/INR towards 70 by 2014.
The Reserve Bank of India‘s recent curbs , like many reactionary capital controls, may act like short-term speed bumps in the rupee’s fall, but in terms of the currency, the more likely effects will be: 1.) Indian firms and individuals who earn their now more valuable profits abroad may be less likely to repatriate them, 2.) Foreign investors, including carry traders, will more likely stay away from India altoghether. Since 2008, FDI into India has declined by 40% while FDI out of India has declined by over 50% to less than US$10bio in all of 2012, so in terms of scale, the RBI move simply does not affect all that much of the invisioned outbound investment by Indian firms.
Momentum-wise, INR is still a “falling knife”, and has yet to show signs of slowing down, let alone turning around. The currency is down 12-14% whether you look at the past 6 or 12 months, and the fall has been accelerating. Even though the size of the fall roughly matches the inflation rate, this pace would take less than one year to make USD/INR pass 70.
Carry could be one factor that may work in INR’s favor, although it has plenty of competition with other currencies also offering 7-12% carry, many of which (BRL, IDR, ZAR) are still viewed more favorably by many EM investors. I haven’t looked at the NDCCS-onshore spread lately (some info on the NDF market here), but just over a year ago an offshore INR carry trader would have earned only about 5-6% vs 8-9% offshore. This spread could be credited to two imbalances: 1.) more offshore investors / carry traders wish to earn the higher INR rates, and 2.) Indian firms who borrow locally in INR might swap in the NDCCS market to pay the lower USD rates (or to match a USD asset investment).
At the time that might have been viewed as a contrary indicator (long INR NDF positions that would need to be unwound, and many probably were unwound this year), and so if these two rates have converged, it would offer a more attractive carry to new longs, and a possible source of demand to push the currency as strong as 60.
Relative to other EM currencies, the rupee really hasn’t been alone in its fall: the Brazilian Real and the South African rand have actually been falling slightly faster, Indonesia is only slightly behind, and Vietnam has probably only held up because it already fell so much before 2010 when its inflation was out of control.
Perhaps more amazingly, the Yen (a base for many carry trades by Japanese and non-Japanese alike, as well as THE G7 currency in Asia) has also fallen almost 20% against the dollar in the past year, which also raises the question of how much of the rupee’s fall is really as simple as weak fundamentals vs. a broader story of the strong dollar in anticipation of Fed tapering. The question of whether the rupee returns to 60 or keeps heading to 72 probably depends mostly on how much the weak fundamentals have already been priced in (like in Vietnam), vs. the broader strong dollar force – the latter meaning more near-term downside for the rupee.
Conclusion: It seems twice as easy to find reasons for the rupee to further weaken rather than recover, and inflation may be the main reason we may not see USD/INR below 60 anytime soon. That said, rupee recovery may rely more on dollar starting to weaken again rather than fundamental strength or real returns in rupee assets.
[Source: OANDA]