Indian two thousand rupee banknotes are arranged for a photograph in Mumbai. (Photographer: Dhiraj Singh/Bloomberg)

Rupee Rally: Fickle Gains Or Supportive Fundamentals?


Much ball-by-ball commentary has been delivered on the recent gains in the Indian rupee. A surge in foreign portfolio flows and a weaker dollar have fired up the latest leg of the rupee rally. If you unpack these factors, you’ll find that some that may prove to be fickle but others are fundamentally supportive of a more stable Indian currency. Stable. Not stronger or weaker.

Portfolio Flows

Let’s start with portfolio flows which have underpinned the recent rally.

Since Feb. 4, the rupee has gained 4 percent. Over this period, foreign investors have found their way back into India, first through the equity route and, more recently, through debt. Foreign portfolio flows into equity markets add up to Rs 44,644 crore for February and March (until March 22). In debt, foreign investors remained sellers in February but have bought close to Rs 10,000 crore so far in March.

While the surge in equity flows has been more dramatic, it is the interest in the debt markets that may prove to be more long lasting.

On the equity side, experts seem to differ on whether the surge in portfolio flows will last.

Sanjeev Prasad of Kotak Institutional Equities believes the equity flows have been driven by an expectation that the BJP-led government will return to power after the general elections and some amount of catch-up after a period of under-performance for Indian equities. Prasad believes the catch-up trade is mostly done and upside to what they consider fair value is limited, he said in a report dated March 19.

In contrast, CLSA’s Chris Wood, writing in his latest GREED & Fear, believes that there is substantial room for foreign investors to add to their India exposure under supportive political and economic conditions. “There is also definitely room for foreigners to increase weightings as they have not added to their holdings in Indian equities for three years,” he wrote.

We won’t hazard a guess.

On the debt side, though, there are fundamental factors which support a resumption of foreign portfolio flows. FPIs were net sellers of Indian debt in 2018 and in the first two months of 2019. This could now potentially change.

The yield differential between developed and developing markets was high even before the U.S. Federal Reserve delivered its dovish surprise last week. Now, the markets know that no more rate hikes from the Fed are likely this year and that QT (or Quantitative Tightening) is coming to an end in September. This has pushed down yields in the U.S. further. Softer economic data has also driven down yields in other developed markets like Germany.

This widens the yield differential even more and increases the attractiveness of Indian debt, particularly if the view on the currency is stable. We do expect to see portfolio flows into Asia picking-up as a consequence of the Fed’s tilt, said Rohit Garg, director of Asia forex and rates at Bank of America-Merrill Lynch. Softness in the dollar will further fuel inflows, he added. Within Asia, Bank of America-Merrill Lynch likes Indonesia and India as destinations for foreign flows. The local interest rate view in India, with another one or two rate cuts likely in 2019, will not alter the yield differential story meaningfully.

A caveat to the return of foreign investors to Indian debt would be any disruptive announcement made by the incoming government. A large transfer of existing capital from the central bank’s balance sheet would fall in this category.

Rupee Rally: Fickle Gains Or  Supportive Fundamentals?

Balance Of Payments

The view on India’s external account has also improved, at least for now. Part of this is linked to the narrower trade deficit on account of lower oil prices and weaker domestic demand. But stronger portfolio flows and more conducive policies for external borrowings have also helped improve the view on the country’s balance of payments.

On the current account, the news is mixed.

At an aggregate level, the trade deficit has fallen to $9.6 billion in February – the lowest since September 2017. The narrower trade gap was driven by lower oil prices. Weak global growth may put a lid on demand-driven gains for oil but enough supply side uncertainties exist to keep the oil price outlook unpredictable. At the domestic end, non-oil, non-gold imports have dropped due to weaker domestic demand. But export growth remains sluggish.

Still, a narrower trade deficit will boost the outlook for the balance of payments, which, at one time in the year, looked like it would turn negative.

Beyond the trade account and the pick-up in portfolio flows detailed above, there are a couple of developments to take note of. The new external commercial borrowing framework has widened the pool of potential borrowers and lenders. As a result, debt capital market bankers are expecting a pick-up in ECB flows this year. One-off flows related to stressed asset resolution deals may also help the overall balance of payments.

Rupee Rally: Fickle Gains Or  Supportive Fundamentals?

A More Fairly Valued Rupee?

If you look beyond the near term, two broader concerns about the Indian currency are getting addressed.

First, the rupee is no longer as overvalued as it was early last year. As such, the risks of an abrupt correction are lower.

The 36-country real effective exchange rate was at 112.76 in February compared to 117.44 a year ago. While it is true that a resumption of portfolio flows can push the rupee back into over-valued territory, the Reserve Bank of India has been a net buyer of forex exchange in the last few months, suggesting the regulator continues to mop up excess dollars. That mop-up has also helped boost forex reserves back to $405 billion now.

Second, the inflation volatility that plagued India and clouded its currency outlook has been contained.

With the inflation targeting framework firmly in place, expectations of inflation in India have fallen compared to previous years. In theory, this narrower inflation differential should also change expectations over currency depreciation over a longer period of time. Whether it does or not will only be clear in hindsight, though.

Rupee Rally: Fickle Gains Or  Supportive Fundamentals?

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.