Rupee Fall: India’s Not The Weakest Emerging Market, Why Is Its Currency So?
Current levels of the rupee are out of sync with fundamentals & weakness is mainly driven by market sentiment, writes Hugo Erken.
The second quarter of fiscal 2018-19 was a stormy one in several ways. Not only did the hurricane and cyclone season reach its peak in September, causing a swath of destruction on the East Coast of the United States (Florence) and in Southeast Asia (Mankhut). Emerging market currencies have been weathering quite a storm as well. A combination of factors were at the root of the global selloff of emerging market assets in the last couple of months, such as the intensifying U.S.-China trade war, the drain of global dollar liquidity by the U.S. Federal Reserve, stubbornly high oil prices and country-specific events in Turkey (concerns about central bank independence and inflation), Brazil (upcoming elections), South Africa (elections) and Argentina (low reserves, high inflation).
The country-specific events seem to have exacerbated the adverse sentiment of investors towards emerging markets in general.
Apparently, investors are still putting the so-called ‘Fragile Five’ countries from the 2013 taper tantrum in one asset class.
The Indian rupee has been the worst performing currency in Asia, losing more than 12 percent against the U.S. dollar compared to the beginning of the year and registering a historic low of 72.97 against the dollar in September. The question we ask ourselves in this column is this: is the heavy selloff of the rupee justified based on the economic fundamentals? Time to grab our raincoats and rubber boots and do some field work.
Approach 1: The EM Weather Radar
It is a bit strange to bring up the term heat-map when trying to get a grip on storms, so let’s refer to our first approach as the emerging market weather radar (which is basically still just a heat-map). This tool is convenient to internationally benchmark the fundamentals that are generally considered to be driving investor appetite for emerging-market assets. These fundamentals consist of three pillars: economic fundamentals (e.g. the current account deficit as a percentage of gross domestic product, political risk, competitiveness), debt vulnerability (e.g. external debt as a percentage of GDP, non-financial corporate debt denominated in foreign currency) and financial market indicators (e.g. market liquidity, volatility and ‘hot money’).
Get the full dataset here.
Without going into details on the results or methodology of the weather radar, it becomes apparent that India is not among the best performing emerging markets in terms of currency fundamentals, but certainly not among the worst performers either.
This underlines that relatively healthy emerging markets, such as India and Indonesia, have been dragged into the current EM currency turmoil by countries performing much worse.
Approach 2: Economic Modelling
Just as national meteorological institutes use models to predict the weather, we can rely on economic models to predict the trajectory of the rupee based on the underlying fundamentals. A newly developed two-equation iterative model integrates a portfolio investment equation with an error-correction equation for the rupee.
This model predicts that in the medium to longer term, India should brace for more rupee weakness due to a further pickup of inflation, structurally lower portfolio inflows and a further rise in oil prices.
Ultimately, the steady-state rate of the rupee would lie somewhere around 74/$. However, we expect the depreciation toward this steady state to be a very gradual process which fits the pattern of a fast-growing emerging market. So, this is not something to worry about.
The speed with which the rupee has been sliding recently is worrying though.
While the rupee currently hovers between 72 and 73, our models arrive at levels of 67 based on the fundamentals.
This means that the large gap between the current value of the rupee and the predicted values is solely driven by bearish investor sentiment. When the dust has settled and investors will re-assess their portfolios based on these fundamentals, one could expect some strengthening of the rupee.
Four Scenarios For The Rupee
What’s more, scenario analyses show that we need to make quite bold assumptions, such as an economic shock comparable with the impact of demonetisation in combination with a severe oil price shock, to justify rupee levels seen in September. This underlines our main conclusion that the current levels of the rupee are out of sync with its fundamentals and the current weakness is mainly driven by market sentiment.
Of course, things can also take a turn for the worse.
In a cumulative stress scenario—which encompasses an economic shock similar to demonetisation, an oil price shock, an acceleration of the U.S. Fed tightening cycle and political turmoil—capital flight from India would accumulate to more than Rs 1 lakh crore until early 2020 and this would push the rupee to levels close to 77.
Policy Response
The rupee rate is not completely at the mercy of external factors. The Indian government has been pursuing different strategies to prop up the rate of the rupee. On Sept. 14 and 15, Finance Minister Arun Jaitley announced that the government would stimulate capital inflows by relaxing rules for foreign investment. Then, on Sept. 26, customs duty was hiked on 19 items in an attempt to curb non-necessary imports, boost exports.
The Butterfly Effect
The big question is if the Reserve Bank of India will step up its efforts to support the rupee with its monetary policy. The RBI has already been using $25 billion to intervene on the foreign exchange market in the last couple of months. But there is no clarity as to what the RBI is going to do with its most important policy rates in the October meeting of the Monetary Policy Committee. Admittedly, inflation has been on a downward trajectory and with inflation targeting as its main policy objective, one might expect the RBI to keep its rates on hold.
For two reasons:
- First, the inflationary pressure in India is far from gone. The low inflation rates in July (4.2 percent) and August (3.7 percent) were mainly due to very favourable food price developments and the high core inflation of 6 percent should be taken as a sign on the wall.
- Second, and this is even more important, the RBI cannot run the risk to underdeliver, especially with the current nervousness on financial markets.
Just as the flap of a butterfly in Brazil could metaphorically set off a tornado in Texas (to quote Edward Lorenz), a failed attempt by the MPC to reassure the markets in October could easily spur another storm of capital outflow, result in further rupee weakness and prop up inflationary risks.
Hugo Erken is Senior Economist at Rabobank; Country Analyst for North America, Mexico and India — RaboResearch.
The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.