A comparison of the rupee with peer currencies in the emerging world reveals some interesting patterns. For one, the rupee is not the sole currency to come under significant selling pressure. Many of the other emerging market (EM) currencies have also weakened in recent weeks owing to a renewed anxiety about Europe and concerns about the overall global growth environment. Global risk aversion meant that capital flows into the EM region remained weak driving EM assets and currencies lower.
Second, there appears to be a clear divergence in the performance between current account surplus EM currencies and current account deficit EM currencies. While surplus currencies have depreciated only at the margin, EM currencies with a current account deficit have had to bear the brunt of the bearish sentiment in the global markets. Thus, given its current account position, the rupee has moved more in tandem with other EM currencies (such as the Brazilian real, the Mexican peso and the South African rand) that have negative current account balances rather than other Asian currencies that are backed up by current account surplus. The Turkish lira (Turkey also runs a large current account deficit) has been the exception and has appreciated mildly in this period. But then it had been beaten down mercilessly earlier.
However, even if current account deficit EM currencies are taken as the effective benchmark, the rupee emerges as the underperformer over the recent past. This seems to suggest that while pan-EM risk aversion has certainly played a roll in pushing the rupee down, anxiety over domestic economic prospects and instability has added to this momentum.
A peer comparison might just give us a tool to gauge where the rupee could find a bottom in this bear market. The rupee has become highly undervalued relative to its peer currencies in Real Effective Exchange Rate (REER) terms and undervaluation itself could reduce the incentive for foreign currency traders to dump the rupee. We made this comparison using the REERs computed by the Bank for International Settlements (BIS).Our conclusion: the rupee is the most undervalued among major EM currencies and is only better placed than the Turkish lira. In asset markets, the extent of undervaluation often sets a floor to a fall in prices. If this logic does work for the rupee, then it could show signs stabilising at a price of 54 to the dollar
A more durable reversal in the rupee is likely only if Western central banks start pumping in liquidity yet again. While the European Central Bank (ECB) and the US Fed might, at the moment, be reluctant to expand their balance sheets in the near term, we believe that they (particularly the ECB) will have to take the plunge to prevent another global financial crisis. This would give rise to the so-called reflation trade and lead to a combination of improved appetite for “risky” EM assets and the liquidity to buy these assets. This could lead to a rally in the rupee.
That said, we rule out the possibility of hefty appreciation in the rupee. We believe that the Reserve Bank of India (RBI) will want to replenish its stock of foreign exchange reserve and will likely use any appreciation episode to purchase the greenback. Hence, RBI actions will likely act as a natural resistance limiting the extent of downtrend in the USD/INR pair. We see RBI stepping up USD purchases around the 50.50-51.00 levels.
Given the risk-off sentiment prevailing at the moment as well as the tightness in international credit markets following the reduced presence of major European banks, it is difficult to disregard credit rating agency Standard and Poor’s downgrade of its outlook on India’s credit rating even if it is simply a reaction to macro developments of which markets and international lenders are well aware. The outlook revision could impinge on capital inflows in the near term. Some foreign investors such as insurance companies and pension funds are bound by prudential restrictions that prevent them from investing in speculative grade countries. Besides, the increased risk of a downgrade could hold them back.
Credit risk spreads for domestic corporations, quasi-sovereign entities and financial institutions could climb up to price in the revised outlook. This could curtail external debt inflows into the country to some extent. The saving grace is that while Standard and Poor’s is decidedly pessimistic about India, its competitor, Moody’s, is far more sanguine about the domestic economy’s ability to withstand prevailing risks, given its high growth rate and an adequate forex buffer. Moody’s affirmed India’s rating at Baa3 (the equivalent of BBB or investment grade) last week and reiterated its outlook on the rating as “stable” just hours after Standard and Poor’s issued the outlook downgrade yesterday. Thank god for these small mercies.
The authors are with HDFC Bank. These views are personal