India’s rupee has been the worst performing currency in Asia, excluding Japanese yen since August 2011. It declined by nearly 22% from August 2011 to December 2011. Although the currency stabilized somewhat in February 2012 after the intervention from Reserve Bank of India, the pain seems far from over. Given the macro-economic situation, both domestically and globally, we might see further depreciation in rupee and we might have to adjust ourselves with lower levels of currency in times to come.

1. Rupee – The Way Ahead
Nishu Agarwal (nishu.agarwal@bmastock.com)
25 April, 2012

2. Rupee – The Way Ahead
 More downside expected: India’s rupee has been the worst performing
currency in Asia, excluding Japanese yen since August 2011. It declined by Asian currency performance vs USD
nearly 22% from August 2011 to December 2011. Although the currency
stabilized somewhat in February 2012 after the intervention from Reserve
Bank of India, the pain seems far from over. Given the macro-economic
situation, both domestically and globally, we might see further depreciation
in rupee and we might have to adjust ourselves with lower levels of
currency in times to come.
 Weak domestic economic framework: Among the Asian currencies, rupee
was one of the worst affected largely owing to India's high current account
deficit, while most other Asian countries have a current account surplus. The
redemption pressure on account of rising short-term external debt also
exposes India's external vulnerability in the wake of weak global capital
markets. The domestic factors that further pressurized the rupee include
slowing growth, a high fiscal deficit, continuous high inflation and lack of Source: Bloomberg
policy reforms
IMF’s economic growth forecast across Asia
 Fragile global economic framework: The global economic situation has 2012 Real GDP YOY% 2012 Real GDP YOY%
worsened following escalating crisis in the Euro zone and the US sovereign (April 2012) (September 2011)
debt downgrade. Under these circumstances of rising risk aversion, China 8.2 8.2*
the emerging economies are bearing the brunt due to the flight of capital India 6.9 7*
towards the USD South Korea 3.5 4.4
Indonesia 6.1 6.3
 Limited tools in the hands of RBI: In order to curtail the weakness in the Taiwan 3.6 5
rupee, the Reserve Bank of India had taken some initiatives. However, the Thailand 5.5 4.8
measures are expected to be short-lived and due to inherent weakness in the Malaysia 4.4 5.1
Indian economy, the depreciation in the currency might continue. The RBI Hong Kong 2.6 4.3
Singapore 2.7 4.3
might continue to intervene in the currency markets to curb the volatility in
Philippines 4.2 4.9
rupee, but ultimately it will be left with limited tools to maneuver *Forecasts were updated in January 2012 Source: Bloomberg

3. Domestic Economic Framework
 Balance of Payment financed by volatile capital inflows: There are two key Rising Short Term External Debt (USD, billions)
issues plaguing India’s balance of payments (BoP): one, the size of current
account deficit is unsustainably large; and two, the majority of financing of
the deficit is via volatile capital inflows that can reverse quickly. During Q3 of
2011-12, India’s BoP experienced a significant stress as trade deficit widened
and capital inflows fell far short of financing requirement resulting in
significant drawdown of foreign exchange reserves. It slipped into the
negative territory for the first time in three years. It had last been in the red
in the December quarter of 2008, soon after the Lehman crisis. The current
account deficit (CAD) widened to US$ 19.6 billion in the same period which
works out to be 4.3% of GDP, up from 4.1% in the previous quarter.
Thus, India is vulnerable to the risk of inadequate financing of the deficit and
to uncertainty regarding the sustainability of financing. Source: Bloomberg
Widening Current Account Deficit (% of GDP)
 Widening Current Account Deficit (CAD): The CAD measures the country’s
external deficit which it needs to cover through borrowings or inward capital
flows or investments. India’s CAD is approaching 4% of GDP which is the
second highest since March 2002. To check the widening CAD, government
allowed freer borrowing from foreign lenders by raising the investment caps
in external commercial borrowings and foreign investment in government and
corporate debt. Dependence on foreign borrowings to finance the CAD is
difficult as repayment becomes harder in the event of a big depreciation.
Source: Bloomberg

4. Domestic Economic Framework
 High oil prices to take a toll on trade deficit: The CAD might suffer further Rising Crude Oil Prices(USD, per barrel)
due to rising trade deficit. India imports nearly 80% of its crude oil needs,
leaving it vulnerable to gains in crude oil prices. Crude oil prices have gained
nearly 30% since October 2011, and continues to gain further on the back of
concerns related to sanctions against Iran by the US and the EU. This will not
only raise concerns over India’s current account deficit, but at the same could
potentially delay monetary easing, thereby coming in the way of an expected
improvement in the domestic growth-inflation balance. Thus, INR’s regional
underperformance is likely to continue if oil price remains elevated.
 Lack of policy reforms to deter FDI flows in India: One solution to check the Source: Bloomberg
widening current account deficit is to encourage non-debt long-term capital Dwindling Monthly FDI (USD, millions)
flows in India i.e. to attract foreign direct investment (FDI) to India.
However, policy paralysis in government is deterring such flows. There is
certainly a large backlog of legislation including bills to modernize indirect
taxation, to boost investment in mining and to facilitate land acquisition.
Executive decisions are also needed to liberalize foreign direct investment
(FDI) in the retail and aviation sectors. Meanwhile, liberalization of the labour
market, which is perhaps the single most important reform, has long been
discussed but is considered politically too difficult to tackle.
In 2010-11, at a time when flows to the rest of the emerging market
economies (EMEs) were heading north, inflows into India were below par.
Source: Bloomberg

5. Global Economic Framework
 Muted global growth: According to the IMF (World Economic Outlook – Jan Gain in USD due to risk aversion
2012), the world GDP growth is expected to decelerate to 3.3% in 2012 from
3.8% in 2011 with recession in the Eurozone and extremely anemic growth in
the UK. This could potentially reduce the appeal for risky assets like INR.
 European Union sovereign debt crisis: Despite continuous efforts, the
European debt crisis which started in late 2009 seems far from over. Although
Greece has managed to win its second bailout package with assistance from
the Troika and private sector involvement to tide over its immediate
redemption pressure in Mar-12, the country still remains vulnerable as
economy has been suffering from recession for the last 3-years and more
Source: Bloomberg
importantly is expected to remain in one for the next 2-years. Lack of growth
will make fiscal austerity extremely challenging amid an unstable political
environment. While sovereign debt has risen substantially in only a few
eurozone countries, it has become a perceived problem for the area as a IMF Projection for GDP Growth (% pa)
whole.
2011 2012
World 3.8 3.3
Advanced Economies 1.6 1.2
 Rising risk aversion leading to the flight of capital towards USD: Due to US 1.8 1.8
deteriorating global growth and escalating EU debt crisis, risk aversion has Euro Area 1.6 -0.5
increased. As a result, the emerging markets are bearing the brunt due to the UK 0.9 0.6
flight of capital towards the USD. Emerging & Developing Economies 6.2 5.4
Source: Bloomberg

6. Limited Tools With RBI
 Large intervention ruled out: The size of currency market today is huge: RBI Net Purchase of US Dollars (USD Million)
~30bn USD a day of onshore and ~40bn USD of offshore trading on a daily
basis. If the central bank decides in favour of an effective intervention, it will
need to place orders worth 4-5bn USD daily. With the present reserves at
270bn USD, it would last for close to 2-2.5 months. The speculators might
latch onto the opportunity to short it in the event of depleting reserves and
try to achieve the fair value. If the RBI intervened to protect or create a floor,
everybody would try to shift monies out of the country at the virtual price
created by the RBI, only to return when the RBI has given up on intervention
and rupee returns to its correct valuations, thereby earning the price
differential. Ultimately, this leads to a sharp and quick depreciation than
would have happened without intervention. The central bank is left with
lower reserves and similar or worst currency pressures.
Source: Bloomberg
 Balance between Inflation and Growth: RBI recently cut the interest rates by
50 basis points. It justified the rate cut on grounds of slowing growth as
exhibited by disappointing industrial production data (4.1% yoy in February Components of India’s Wholesale Price Index
and 1.1% in January). It, however, acknowledged persistent upside risks to
inflation. Much of the recent decline in WPI has been due to temporary
factors - base effects and a seasonal drop in food prices, especially vegetables.
Food-price inflation is already picking up again. Belying the moderation in
headline WPI, March wholesale prices of primary food articles rose 9.94% yoy
compared with 6.07% in February. The fuel inflation is also set to increase
due to gain in crude oil prices. Together, food and fuel items have a large
46.5% weighting in the calculation of India’s WPI. Thus, if the inflation
persists, the real interest rate would continue to remain in the negative
territory in the Indian economy, further leading to lower levels of currency.
 Thus, despite being at lower levels, INR might decline further, to reach close
to 55-56 levels in the short term. Source: Bloomberg

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