Low interest rate in India is coming at the cost of rupee exchange rate

There is high negative correlation between the India 10-year and US 10-year bond yield spread and rupee-dollar exchange rate

India’s low-interest-rate regime in recent years has come at the cost of the rupee.

 

As the interest-rate difference between bonds in the United States (US) and India has steadily narrowed in recent years, the rupee has depreciated against the dollar at a steady pace.

 

In the past one year, the spread between the yields on government bonds — India 10-year and US 10-year — is down 70 basis points from 2.61 percentage points at the  end of June last year to 1.91 percentage points on Tuesday.

 

In the same period, the rupee is down 3 per cent against the dollar from 83.73 to 85.97 on Tuesday. 

 

The inverse relationship between the yield spread and the rupee-dollar exchange rate is not new. There is a high negative correlation between the India 10-year and US 10-year bond yield spread and rupee-dollar exchange rate.

 

In the past 25 years, the rupee has tended to depreciate whenever the yield spread between India and US bonds has declined. In contrast, the Indian currency has appreciated against the dollar or has stayed stable during periods of a widening yield spread.  

For example, in the past 10 years, the spread over the India 10-year bond and US 10-year bond is down by nearly 360 basis points from 5.51 percentage points in June 2015 to 1.91 percentage points now. In the same period, the rupee has depreciated nearly 26 per cent from 63.6 to 85.96 (see adjoining chart).

 

 

In contrast, the rupee appreciated against the dollar in 2004 and through to 2008 as bond yields in India rose at a faster pace than in the US, leading to higher yield spreads.

 

The yield spread widened from a low of 0.8 percentage points in October 2003 to around 4.5 percentage points in March 2008. In the same period, the rupee appreciated from 46 to around 40 to a dollar. 

 

Experts attribute this negative correlation to the spread impact on capital inflows.

 

“A lower yield spread between the India and US bonds makes the Indian market less attractive to foreign portfolio investors, leading to lower foreign portfolio investment (FPI) in our bond market and vice versa. Lower capital inflows in turn put pressure on the rupee, given that we consistently run a current-account deficit,” said Madan Sabnavis, chief economist, Bank of Baroda.

 

The recent dollar depreciation should have led to an appreciation in the rupee but the Indian currency has depreciated in the past two months as yield spreads have narrowed, he said. 

 

The decline in yield spreads is attributed to the Reserve Bank of India (RBI) cutting rates faster than the US Federal Reserve (Fed). The Fed has kept its policy rate or Fed Fund steady, fearing higher inflation, while the RBI cut the repo rate by 100 basis points this calendar year.

 

Others say, apart from this, the rupee has faced pressure from lower economic and corporate growth in India.

 

“The yield spread is only one of the factors affecting the exchange rate. The currency is vulnerable to lower economic growth, which has an adverse effect on foreign direct investment (FDI) and FPI. Both FDI and FPI are on a downward trajectory, building pressure on the rupee,” said Dhananjay Sinha, co-head, research and equity strategy, Systematix Institutional Equity.

 

According to him, a lower yield spread is more of a symptom of lower economic and corporate growth and a lack of investment activity in the economy rather than the cause itself.

 

“A meaningful pickup in growth and investment will lead to greater demand for long-term capital, leading to higher interest rates and higher yield spread as we have seen in the past.”