Rupee outlook: Manageable downside risk from US Fed policy action

The rupee has been one of the better performing emerging market (EM) currencies in 2015. Most EM currencies saw significant depreciation this year: Brazilian real (45 per cent), Turkish lira (24 per cent) and Russian rouble (10 per cent), whereas the rupee fell only 5.6 per cent.

The rupee’s outperformance reflects India’s better macroeconomic prospects vis-à-vis other EM economies. At a time of global slowdown, India is growing at about 7.5 per cent. The decline in commodity prices, which has affected most EMs negatively, has been one of the key factors in positively transforming India’s trade and current account and also in improving its inflation and fiscal situation.

Low commodity prices, particularly oil, have kept the current account deficit (CAD) at 1.1 per cent of GDP (approximately $25 billion), reducing the need for global capital flows to fund our annual trade. The fact that the CAD can be funded by FDI alone, which is a much more stable form of funding, reflects the resultant strength of India’s external sector.

Global investors are cognisant of India’s relatively better growth - Q2’FY2016 GDP growth was 7.4 per cent reflecting that the business cycle has bottomed out and that there are early signs of recovery visible. This has meant that global investors still see India as a favourable investment destination. Overall capital flows in 2015 have been $12 billion. Net foreign direct investment flows have seen robust performance at around $27 billion during 2015 displaying the strong interest for global business to participate in India’s growth.

The interest in Indian debt remains well supported. The permitted amount of FII debt has been fully used up on the G-Sec side since January 2015 and close to 75 per cent on corporate bonds.

Looking ahead, current CAD levels of 1.1 per cent of GDP are expected to hold given subdued outlook on oil. However, recent export performance has been a cause for concern. Exports have contracted consecutively for 11 months and are expected to be lower than $300 billion for FY16, the lowest since FY11. The dismal performance is partly due to cyclical factors, such as lower commodity prices and subdued global demand, and partly due to lack of exports competitiveness.

The government’s reforms aimed at easing the way business is done are expected to improve competitiveness and help exports in the medium term. The 13 per cent overvaluation of the rupee would, in the meantime, not provide pricing support to exports, as competing countries have seen larger currency depreciation. This should prevent the rupee from appreciating, as RBI intervention would ensure that increase in rupee valuation does not cause a structural weakness in the exports and external sector.

Of course, there will be spurts in rupee buying based on event driven capital flows. This was visible in September when the RBI increased debt limits for FII investment which saw inflows of $2.5 billion.

The coming weeks are going to see some critical global factors. The US Fed is expected to increase rates for the first time in nine years, which could cause some volatility and depreciation in EM currencies. However, the Fed move is widely expected as is the fact that they will articulate a well moderated path of future hikes. So, the depreciation in rupee will not be too sharp.

In summary, the improved confidence in domestic economy, a manageable CAD and the FII debt limit hikes should support the currency in the medium term. However, in the near term, rupee is likely to be guided by the Fed’s actions and could move towards 67-67.50 range.

The author is senior general manager & head—global markets group, ICICI Bank