Rupee set for hard landing with target at 57

Rupee looks set for hard landing with target at 56-57

Has USD/INR shifted into a new range of 52-57? Let us get into some analysis. I closely track four factors to set up directional guidance for rupee; Current Account deficit (CAD), Balance of Payment (BOP), flow momentum in the forward market and price behaviour of USD Index/Crude oil. The system is short of $7-8 billion every month to meet its obligations on the current account. This deficit has to be bridged through net inflows into Capital Account (for neutral BOP) and/or excess supplies in the forward market to provide short/medium term stability for rupee. The near term behaviour however is linked to direction of USD Index and Crude oil.   

There are no quick-fix solutions to address ballooning CAD mainly from strong rally in commodity prices since December 2008 (from low of $36.20) and subdued export growth since post-Lehman financial (and economic) crisis of the Western world. The Government and/or RBI could do little to address the related impact of higher dollar pay-out on imports and reduced supply of dollars on cut in demand for India’s goods and services from the external sector. At best, they could provide incentives to exports to maintain its competitiveness and allow rupee depreciation (from 39.20). Government also absorbed resultant cost into its fuel subsidy without allowing pass-through of higher cost of imports into consumers to cut its impact on inflation. On the assumption that CAD deficit is there to stay over long term, it is important to ensure that deficit is bridged through Capital Account flows from long term direct investments; not from hot money FII flows. RBI has done its best to provide relaxations in accessing off-shore debt market and attractive post-tax returns for NRIs; these measures have helped to prevent the worst for rupee without a permanent relief. The solution to this will be to roll-out next generation reforms and open up core sectors to foreign direct investments. It is also important to quickly get into low inflation and high growth economic dynamics for shift into high liquidity and low interest rate monetary regime. This will also cut the conflicts of interests at play between growth versus inflation and tight rupee liquidity versus dollar sales. These conflicts do not provide confidence to take stake holders on RBI’s ability (and capability) to defend rupee slide. The next important factor is linked to “sentiment” (and future outlook) with the need to retain currency stability into the long term to cut “lead and lag” play between imports and exports. When the system is short of $8 Billion per month, combination of importers covering future payables and exporters holding on to dollars till actual realisation will be disaster for rupee. It is essential that rupee bullish sentiment extends into the future making forward dollars attractive to exporters and provide good comfort to importers to refrain from paying premium to acquire forward dollars. Taking all these together, it is not difficult to come to a conclusion that these structural issues have no immediate remedial measures. If at all, it would be a long-drawn process to shift into high growth; low inflation; high liquidity and low interest rates operating environment which would in turn remove the fears over fiscal and current account deficit. These are essentials for off-shore investors to consider India as an investment destination by automatic choice.

The focus is now into market dynamics to set up clear direction for rupee which can be supportive to exporters without hurting price dynamics of imports and its impact on inflation. We need to watch behaviour of USD Index and BRENT Crude for this purpose. USD will retain its safe haven status and maintain its command over the Euro till QE3 comes into play. The economic data from the US provide possibility of QE3 roll-out in last quarter of 2012. This would shift the market into “risk-on” mode to drive USD lower; the best case scenario for USD Index seems to be not beyond 81.50-82.00 with the risk of sharp reversal from there into 75.00. On the other hand, BRENT Crude is already down from recent high of 128.40 to 110.34 and looks good for extended weakness below $100 into the short/medium term; better than the notional level of $115 reckoned in Budget FY13 for CAD and fiscal deficit. These two factors of downtrend in BRENT Crude and USD Index into short/medium term provide great relief for rupee into medium/long term. This would also mean that rupee can be allowed to depreciate into short/medium term to provide greater comfort to exporters to compete with their peers taking comfort from significant dilution in fears over fuel cost subsidisation, fiscal deficit and inflation. There are not enough options with RBI to arrest rupee weakness. RBI’s balance sheet is short of dollars and domestic system is short of rupees. It is also not practical at this stage to shift to high liquidity and low interest rate monetary regime to focus on growth at the cost of inflation. Till these structural issues are sorted out to remove the conflicts of interests in play, the system may need to accept gradual depreciation of rupee into 56-57 by September 2012; 5% loss in exchange rate against 15% gain in dollar cost of import of crude oil will not hurt inflation even if cost pass-through is achieved. By then (September 2012), if QE3 is rolled out, resultant dollar sell-off would provide rupee rally from 56-57 to 52-51. Let us stay prepared for shift into a short term range of 52-57 with initial bias into higher end. While the expectation of sharp reversal from 57 to 52 is valid, we shall review this as rupee approaches 56-57 by July-September 2012. It is now important for importers to stay covered on payables up to September 2012 (current September 2012 dollars at 55.25) while exporters await spike in value of September 2012 dollars to 58. There is risk of FII pull-out to drive NIFTY into 4775-4525 along with rupee weakness into 56-57 but they are expected to get back with force at these levels to provide momentum to rupee rally from 57 to 51. This phase of run into difficult terrain may be considered good for the overall interest of the Indian economy!  

Moses Harding  

Head – ALCO and Economic & Market Research

IndusInd Bank, Mumbai