The outlook for rupee has improved, amid better domestic macro fundamentals and strong capital flows. Global economic challenges and rising risk aversion, which weighed on the rupee earlier, have had limited impact in the recent past.
Even now, the challenges for the global economy continue to persist. The International Monetary Fund (IMF) recently reduced its 2016 global growth forecast to 3.1 per cent from the earlier 3.2 per cent. The revision reflects a more subdued outlook for advanced economies following the Brexit vote in June. Subdued demand conditions are further reflected in low inflation prevailing worldwide. These developments have put downward pressure on global interest rates as most regions, except for the US, are now expected to remain accommodative for longer.
However, there is a growing sense that some form of fatigue is setting in among central banks with the monetary policy impact. This could result in a sharp sell-off in the bond markets in advanced economies and trigger spillover reactions across other assets class, too. In such a scenario, risky assets will be sold off and depreciation pressure on the rupee is likely to increase.
On the other hand, improving domestic macroeconomic backdrop will continue to keep the rupee afloat.
Improvement in the external sector outlook has been the key driver for a stable rupee. The economy is now in a comfortable position to finance the current account deficit by stable flows such as foreign direct investment alone, without resorting to FII flows. The economy is likely to end the current financial year with a comfortable balance of payment surplus despite significant FCNR (B) outflow.
India's foreign exchange reserves have also increased to $368 billion, which yields an import cover of Rs 12 a month, a significant improvement from the low of seven months during the taper tantrum episode of 2013. Our reserve adequacy calculation suggests there is scope to increase FX reserves further to $400 billion.
As a result, the rupee has broadly traded in the range for the past few months and seen relatively lower volatility than most other currency pairs in the EM (emerging market) currency basket.
Towards the end of the year, global monetary policy differentials will play out. The US Fed will resume its rate tightening, likely to result in a stronger dollar. However, a cautious approach by the US Fed is likely to be less disruptive for EM currencies. The outcome of the Presidential election and Opec's oil market meeting in November are sources of possible volatility for the currency market.
To counter the impact of FCNR (B) outflow on the rupee, the Reserve Bank of India (RBI) has allowed for greater appreciation in the rupee, to address market concerns regarding dollar shortage. We believe RBI will shift to the earlier regime of gradual depreciation in the rupee once the FCNR (B) flows are out of the way. Against this backdrop, we believe the rupee is likely to trade in the range of 68-69 by the end of the financial year.
The author is Group Executive, ICICI Bank
