Rupee to consolidate, barring intermittent spikes

Rating agencies have taken note and upgraded India's rating outlook to positive

The rupee has remained stable over the past few months, despite significant cross-currency movements globally. The outperformance reflects improvement in India's macroeconomic variables vis-à-vis other emerging market (EM) economies over recent years. Rating agencies like Moody's have taken note and upgraded India's rating outlook to positive.

India's external sector has witnessed the most notable improvement and the current account deficit (CAD) has reduced from 4.7 per cent of the gross domestic product (GDP) in FY13 to an estimated 1.1 per cent of GDP in FY15. Crude oil prices in the range of $60-70/bbl bode well for the outlook.

The other positive factor for the currency has been strong capital flows during 2014-15. These are partly a reflection of exogenous factors such as an easy global liquidity environment and partly the optimism around the central government's reform agenda.

Despite these positives, we remain cognisant of potential headwinds that might weigh on the rupee trajectory. First, sustainability of the external sector improvement has not been cemented. Regulatory intervention by the government in gold imports and a steep decline in international crude oil prices led to a lower gold and crude import bill over the past few years. Recent trade data point toward weaker exports growth and a pick-up in non-crude non-gold imports in FY15.

The export sector is further impacted by the rupee outperformance vis-à-vis other currencies. This is reflected by the overvaluation on a real effective exchange rate basis. The alignment of the rupee with EM peers is one mean to restore exports sector competitiveness. Addressing this is crucial to sustain the external sector performance from a medium-term perspective.

On the global front, the US Federal Reserve's monetary policy stance through 2015 will be a key variable to provide direction for financial markets. Specifically, the first rate rise by the Fed is likely to result in gradual strength in the dollar, putting downward pressure on the rupee. Capital flows to EM assets might slow down, as global asset managers rebalance their portfolio in favour of US assets though the impact might be limited amid the easy policy stance of the European Central Bank and the Bank of Japan.

The Reserve Bank of India (RBI) has highlighted the risk of unhedged foreign exchange (forex) exposure of the corporate sector. The risk can exacerbate depreciation pressure on the rupee in a scenario of external shock.

The risk to the global financial system has clearly increased, as we approach the first Fed rate increase. However, we believe India is relatively better prepared to handle the volatility as compared with the taper tantrum episode of 2013. RBI's policy of active market intervention has created a lower bound for the currency and helped garner forex reserves. The confidence in the economy has increased amid the rising forex reserves, at $340 billion, and a higher import coverage ratio of nine months.

On balance, we expect the rupee to trade in the range of 62-64 to a dollar, with a depreciation bias. In a scenario of extreme forex market volatility, though the currency could overshoot the range, we expect it to revert to the mean from a medium-term perspective.

The author is senior general manager and head-global markets group, ICICI Bank