USD/INR outlook for FY13

Rupee Outlook for FY13

Rupee fortunes continue to stay dependent on hot money FII flows

FY12 was one of the worst years for rupee; down from 44.59 to 50.87 at an annualised rate of over 14%. The most alarming phase was between July to December when rupee went down from 43.85 to 54.30 by 24% in less than 5 months time. On the other hand, USD Index was up from 75.86 to 78.95 in FY12 with an annualised gain of over 4%. There are many fundamentals reasons for underperformance of rupee but most striking is its dependence on lumpy FII flows; weak fundamentals are discounted on good FII flows and get exaggerated on FII pull out. There is no political consensus to attract FDI into India to stay less dependent on volatile FII flows. It is not unfair to say that rupee exchange rate is controlled by FIIs and resultant excessive volatility makes things difficult for RBI.

The fundamentals woes for rupee arising from huge Current Account deficit continue to stay valid for decades now. There are no signs of structural remedies to cut dependence on imports and to boost exports. There is constant need to bridge this gap through accelerated and sustainable flows through capital account and maintain over-valuation of forward dollar to keep forward market in supply driven mode; simultaneous pressure from forward market and decline in capital account flows will put pressure on rupee. Then, there is another major issue of bunched up dollar demand in the cash market from PSU entities with no efforts to smoothen this demand into a phased manner. Given these complexities and high dependence on external sector (and forces), rupee will continue to stand out in relative performance to either the US Dollar or other peer group currencies with excessive (or extended) strength or weakness.

What is the outlook for FY13? There are no signs of improvement in Current Account deficit given the high crude oil price and low demand for India’s goods and services from the external sector. The support from carry-trade flows is on decline having lost the cost advantage driven by higher liquidity/credit spread and FX premium. Given this scenario, it is important to study FII behaviour to project a trading band for rupee for FY13. FIIs continue to view India as attractive destination and find debt and equity assets as good for investments; being member of BRICS community helps. The liquidity over-hang in Western markets and low interest regime till 2013-2014 is positive for rupee. Interest rates in debt market will continue to stay attractive in FY13 given the limited downside pressures for sharp reversal in interest rates. There are no signs of bearish set up on equity assets despite outperformance of western bourses over India. DJIA is below the pre-Lehman Bros high of 14198 by 7.5% (at current 13250) while NIFTY is behind by 19% from 2008 high of 6357. Then, there are political; economic and monetary issues providing strong headwinds to accelerated FII/FDI flows. It is critical for establishing sustainable bullish set up in equity market to prevent rupee weakness. The dilution in rate cut expectations will keep investor appetite intact for fixed income assets. It is also important that western economies do not get into either recessionary mode or strong economic revival mode; either of which can trigger FII pull-out. The lessons from the past is that bearish set up on rupee could be swift while bullish reversal will be shallow and would need RBI’s support; downside risks can be sharp and upside gains will stay limited to maintain export competitiveness and the need for RBI to shift rupee assets into dollars in its Balance Sheet.

What is the trading range for rupee in FY13? There are lot of factors to track to fix a broad range for rupee. Factor that could put pressure on trade gap is the behaviour of BRENT Crude while economy is in business as usual mode to effect significant variance in top-line imports and exports performance. The movement in Balance of Payment is critical. We have seen huge deficit in Q3 of FY12 triggered by FIIs exit but it was good to see the re-entry in Q4 that should shift BoP into positive in Q4; also supported by accelerated NRI flows on deregulation of interest rates. It needs to be seen whether RBI will retain the tax advantage available to NRE Rupee deposits. There are no bullish cues at this stage to take comfort from sustainable FII flows; it could be volatile as seen between Q3 and Q4 of FY12. There is no clear trend on USD Index; relatively good performance of US economy and expectation of QE3 will keep global investors in “risk-on” mode to provide consolidation with no clear signals of establishing either a bearish or bullish trend. The trading range for USD Index for FY13 is expected to be at 76.10-82.60 (EUR/USD at 1.27-1.38). There is serious concern from crude oil price; excessive liquidity in western markets could drive commodity prices up with added fears from geo-political concerns. It is difficult to get clear trend on the three most critical factors of FII behaviour; BRENT Crude price and USD Index. This would mean that domestic cues should establish “pull” triggers to attract external liquidity. It is important to get the trend right on growth; inflation and fiscal consolidation. The shift of RBI into growth supportive stance and efficiency of the Government to manage costs will be critical at this stage. There are strong reasons to believe that RBI and Government will take necessary steps to get the Indian economy out of the woods that could provide great comfort to FIIs to stay invested in Indian markets; opening of carry-trade flows through shift of credit demand from rupees to foreign currency will be icing on the cake. The trading range for rupee for FY13 is expected to be at 47.80-52.15 with overshoot limited to 46-53. There is no clarity on establishment of clear trend at this stage; hence it would be prudent to close exchange rate exposures on move into outer ends of the said range. The strategy (and recommendation) in MARKET PULSE was to sell December 2012 dollars above 54.00 and to sell March 2013 dollars above 54.50; reversal from these levels (on recent spot weakness into 51.50) has been sharp. The chance of extended gains in rupee into 47.80-46.00 is high while weakness beyond 52.15-53.00 is low. May be, FY13 is the year for the rupee bulls having lost the battle in FY12!

Moses Harding