Indian Rupee And The Law Of Unintended Consequences

The rupee fell to 75.09 against the U.S. dollar in early trade but rebounded to trade back below 75 by mid-day. Last week, the Indian unit depreciated the most in two years, recording a fall of 2.2%, according to forex advisory firm IFA Global.

G-SAP & The Rupee

The fall in the rupee gathered steam after the Reserve Bank of India announced a new bond purchase programme called G-SAP, under which it will buy Rs 1 lakh crore in government securities in the April-June period.

To be sure, the central bank has already been buying bonds both via open market operations and in the secondary markets. Currency markets, however, saw this as a more explicit move towards quantitative easing-like policies, which could be negative for the rupee.

“Such an overt QE-like approach marks a shift in strategy from the ‘soft yield curve control’ approach that the RBI was following for much of last year in our view,” wrote Abhishek Upadhyay and A Prasanna of ICICI Securities Primary Dealership, in a report dated April 12. The forex market seems to have interpreted the policy as dovish, they said.

It wasn’t the RBI’s G-SAP programme alone that led to a shift in the rupee’s direction, which until March was among the best-performing currencies in Asia.

The currency markets had seen a build-up of carry trades on expectations that the rupee was set to continue appreciating. Following the RBI’s announcement, foreign portfolio investors chose to unwind some of these positions, leading to a depreciation in the currency. “FPIs who had been receiving carry in offshore unwound their positions causing the rupee to weaken,” said IFA Global. The RBI, it said, may have chosen not to intervene as recent rupee outperformance had caused it to become overd. “The RBI would have seen this bout of rupee weakness as correction of that overvaluation,” said IFA Global.

Changing Macroeconomic Mood

Alongside, uncertainty around India’s macroeconomic fundamentals has risen. The second wave of Covid-19 infections had led to localised lockdowns, leading to questions over the economic impact.

While the RBI held on to its forecast of 10.5% GDP growth in FY22, concurrent indicators such has mobility have fallen due to the surge in infections.

“The bigger question is if the economy’s fundamentals have shifted enough to trigger a sharp unwind of short dollar positions. Further, whether the RBI would intervene to curb volatility is a key issue. There is a reason for some optimism on the latter given the strong buffer of forex reserves held now by the RBI...” said ICICI Securities Primary Dealership in its report cited above. “If the market reaction on the policy day was any sign, skewed market positioning could still hurt in the near term if there are more negative catalysts.”

In addition, India has returned to a current account deficit in the October-December quarter as domestic demand strengthened. The same is likely to continue in FY22.

“In our view, the ‘golden period’ of external sector comfort in 2020 — which was led by domestic demand-led slump in imports, lower commodity prices, alongside strong capital flows — is behind us. The key unwind this year is likely to be on the merchandise trade deficit front, where a rapid domestic demand recovery and higher commodity prices are likely to keep import growth elevated, even as export growth is improving,” said Nomura economists Sonal Varma and Aurodeep Nandi in a report dated March 31.

A return to current account deficit could mean depreciation pressure on the currency if capital inflows slow. In 2020, India received a net inflow, across equity and bond markets, of more than Rs 1 lakh crore, National Securities Depository Ltd. data showed. So far this calendar year, net inflows are at above Rs 54,000 crore, although April has seen small selling with a net outflow of about Rs 941 crore, according to NSDL data.

Two-Way View

Given the conflicting factors, the outlook for the rupee varies.

ICICI Securities Primary Dealership expects the currency to weaken but does not see it fall below all-time lows.

“Unless India really loses control of the pandemic over the next month, we don’t expect Indian rupee to veer close its earlier low (of just a tad below 77 levels) that was seen around April last year. We do believe some fall is likely however in the baseline, may be closer to 76 levels,” Upadhyay and Prasanna said in their report.

Barclays, on the other hand, is expecting a return to appreciation.

“We are constructive on the rupee over the medium term and forecast the currency at 73.00 by year-end,” Ashish Agrawal, head of forex and emerging market macro strategy research at Barclays, said in a report dated April 9.

“Upward revisions to India’s growth trajectory, fiscal consolidation and accommodative monetary policy bode well for capital inflows. We expect rupee risk premia to remain low and think risks of any sustained widening are limited. We do not expect the financing of a small current account deficit, as it normalises after the surplus in FY20, to pose a challenge. The global backdrop also remains favourable for EM, as growth prospects improve while policy settings remain supportive,” Agrawal wrote.