Opinion: Brace for more rupee volatility

This August has been marked by significant volatility in the global currency markets. The contagion related to the crisis in Turkey has seeped into other emerging market currencies. This has caused the rupee to depreciate as well, and test fresh all-time lows. While macroeconomic troubles were anyway brewing in Turkey, sanctions imposed by the US on imports of metals from that country precipitated a sharp slide in the Lira, which has depreciated relative to the US dollar by 22 per cent in August 2018 alone (up to August 20, 2018) and by a massive 51 per cent since the beginning of FY 2019.

The risk aversion which has been triggered by the Turkish concerns crept into other emerging market currencies such as the South African Rand, Russian Rouble and Brazilian Real, which have depreciated by around 4-11 per cent relative to the US dollar in August 2018. Other emerging market currencies, such as the Chinese Yuan, Philippine Peso, Korean Won, Mexican Peso, Malaysian Ringgit, Indonesian Rupiah and the INR, have recorded a modest decline of up to 2 per cent against the US currencyin August 2018, amid a larger depreciation of 3-9 per cent in FY 2019 to date.

Within this set of countries, the rupee has been one of the weaker performers. It had already depreciated by over 5 per cent in the first four months of FY2019, driven by the concerns regarding global trade wars and the weakness in the yuan, a year-on-year (YoY) rise in crude oil prices and foreign portfolio investors’ (FPIs’) outflows from the Indian markets. Subsequently, it has depreciated relative to the US dollarby a further 1.8 per cent in August 2018 resulting in a fresh all-time low of 70.23/US dollar(RBI reference rate) being recorded on August 16. The RBI intervention has helped to ease the volatility in the INR. FY2019 had commenced on a positive note, with an uptick in the Indian foreign exchange reserves to an all-time high in April 2018. This was followed by a slide, led by the RBI’s net intervention in the spot market to the extent of $14.4 billion in Q1 FY2019. Notably, the size of this intervention rivals the sale of $14.3 billion that the RBI had undertaken during May-September 2013, amid the taper tantrum.

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Intervention is likely to have continued in July-August 2018 as well, given the further dip in the foreign exchange reserves. Moreover, the repo rate hike in August 2018 helped to revive the FPIs’ appetite for Indian debt, which was expected to stabilise the INR. Nevertheless, the global trends and risk-off sentiment have resulted in a 2 per cent depreciation of the INR relative to the US dollarso far in Q2 FY 2019.

Since most emerging market currencies are recording some depreciation, the rupee must weaken to protect the competitiveness of its exports. At the same time, with the extent of the INR weakness, only modestly larger than many of the other emerging market currencies, it is unlikely to appreciably improve the volume growth of Indian export.

Looking ahead, risk sentiment, dollar strength, broader emerging market currency movement, the trend in crude oil prices and the RBI’s actions will drive the outlook for the rupee. The expectation of continued monetary tightening by the US Federal Reserve and intermittent flaring up of concerns related to geopolitical tensions and trade wars may prolong the risk-off sentiment, which will maintain the secular strength of the US dollarin the rest of this calendar year. However, questions regarding the sustainability of US economic growth over the medium term may dampen the dollar rally going forward.

Crude oil prices continue to display a volatile trend, driven by geopolitical risks and the balance of global demand-supply conditions and inventories. Since India is one of the larger oil importers in the emerging market pack, the trend in crude oil prices tends to negatively affect many macro fundamentals, including the outlook for inflation, the twin deficits and economic growth, and rapidly transmits into the rupee and bond yields.

The CPI inflation in Q2 FY2019 is likely to undershoot the estimate of 4.6 per cent made by the Monetary Policy Committee (MPC), reducing the likelihood of a rate hike in the October 2018 policy review which may have an impact on the sentiment toward the INR. The latter would in turn influence the FPI’s decision to enter the Indian debt market, following the revival in inflows that was seen in August.

Other domestic factors that would influence the trend in FPI investments as well as the INR include the momentum of domestic economic growth, as well as concerns regarding the twin deficits. Despite the intervention, India’s foreign exchange reserves remain sizeable at around 10 months of FY 2018 merchandise imports. Moreover, its external debt metrics remain moderate, offsetting some of the concerns posed by the likely rise in India’s current account deficit to 2.7 per cent of GDP in FY2019 from 1.9 per cent of GDP in FY2018. Overall, we anticipate that the RBI is likely to assess the trend in the INR vis-à-vis other emerging market currencies, to determine the extent to which it should intervene to reduce the volatility in the currency.

Given the prevailing risk aversion in the global markets, the rupee may sporadically cross 70/US dollarbefore retracing to 69/US dollarlevels. The cross rate is expected to display two-way volatility going ahead, and average Rs. 68.5/US dollarin FY2019. Indian corporates that are unhedged may be in for testing times especially if they have a substantial volume of external debt to be serviced in the next year.

(This article was first published on The DNA. Read the original article.)

(Disclaimer: The opinions expressed above are the personal views of the author and do not reflect the views of ZMCL)