INR: Appreciate, for now, but be cautious.
The recent INR strength has been due to a confluence of favorable domestic and global conditions. While the appreciation is likely to continue in the short term, we need to be cautious on the medium term. Tightening global financial conditions, political and policy uncertainties and geopolitical risks would continue to shape the EM FX outlook even as expectations remain of a relatively weaker USD. However, INR would find some support from its fundamentals and likely outperform most EMs in FY2018. We expect the INR to average 66.2 against the USD in FY2018 within a range of 62.5-67.5.
Caught off guard on FPI flows
INR has had a steady appreciation since the start of CY2017—in line with EMs. In our earlier report on FX outlook (Chaotic spaces, March 10) we had expected some EM FX strengthening in the near term on account of a relatively weaker USD and benign global environment post Fed's March policy. But we were clearly surprised with the recent pace of INR appreciation. Apart from a weaker-than-expected USD, loss of steam of global reflation trade has pushed significant flows into the EMs. INR has outperformed most of the EM pack (Exhibit 3) as the global factors were further aided by domestic factors such as (1) strong political mandate for BJP in UP elections and passage of GST bill and (2) a hawkish RBI stance.
INR's catch-22 situation
There seems no near-term consensus on the ongoing INR appreciation. While foreign flows have continued, market perceptions of limited ability of the RBI to intervene in spot FX market may further be adding to the long INR positioning. On the other hand, tightening of domestic liquidity or stance on the same could be de-facto positive for INR. Though RBI has been strategically intervening in both spot (liquidity positive) and forward (liquidity neutral) markets, liquidity and FX management could get more complex unless the sterilization tools are used. A generalized expectation of exporters and importers on near-term appreciation of INR owing to these factors is likely leading to further build-up of positioning on the currency. Besides, this is increasing companies' risk appetite on taking further un-hedged foreign currency exposure.
Short-term INR strength may give way to INR weakness in latter half of FY2018
Even as we expect INR to remain strong in the next 1-2 months, we expect some correction during the rest of FY2018. Much of the move has come on the back of record flows, which are unlikely to continue through the year. While it would be premature to time any outflows, we should be cautious of the negative risks. While we have been arguing for a limited USD appreciation over the course of FY2018, we remain wary if this would imply a great year for EM FX based on possible realignment of global risk appetite due to G-4 policy stance, US and Europe political uncertainty and geopolitical risks. For India as well (partly in line with other EMs), the gradual realignment of rates in the US and increase in inflation will lead to narrowing of the real interest rate differential, thereby reducing incentive for flows for India (Exhibit 4). However INR may still outperform its EM peers, supported by (1) India's relatively lower dependence on external trade, (2) RBI's hawkish stance and (3) relatively strong policy and macro fundamentals. For FY2018, we revise up our estimate for average USD/INR pair to 66.2 against earlier estimate of 68.1 (Exhibit 5). This is largely to factor in realignment to a strong 1QFY18 even as we continue to expect the INR to see phases of weakness in FY2018. We expect USD-INR to range 62.5-67.5 in FY2018.
India: A word on currency appreciation
- INR overvaluation. India's Real Effective Exchange Rate (REER) has been suggesting that INR has been in the overvalued zone for quite some time (Exhibit 6). REER valuation reverts every 2-3 years (relative to its 2-3 year average) and REER has been indicating overvaluation since March 2014. Even through phases of nominal depreciation, the REER has been relatively strengthening over the past few years. The overvaluation essentially implies that amid limited correction in inflation and productivity dynamics between India and its trading partners in the near term, the nominal exchange rate may have to correct to compensate for the REER overvaluation. In FY2018, even as we expect a gradual nominal INR depreciation in 2HCY17 as the recent risk-on phase fades, we may continue to see the REER appreciate mildly over the course of the year, largely as INR outperforms its EM trading partners. Hence we may not see much near-term correction in REER, which keeps alive the risks of sharp nominal depreciation, though timing is uncertain.
- Loss of competitiveness. The broad-based REER indicates that India has lost its trade competitiveness over time. This is likely to be more pronounced in labor-intensive industries such as textiles and leather, gems and jewelry, etc. (Exhibit 7). The Economic Survey 2016-17 argues that the IMF and RBI measures of REER overstates the loss of competitiveness and one of the reasons is that they consider a broad basket of trading partners and not focused on manufactures' trade or labor-intensive manufactures' trade. Even with a refined weightage pattern, the Survey concludes that there has been around 8-10% loss in competitiveness since January 2014 (against the conventionally tracked 36-currency REER of the RBI, which shows 12% loss in competitiveness) until October 2016. Along with the exchange rate competitiveness loss, India lags significantly in productivity too. Most of the labor-intensive segments suffer from a combination of deficiencies in areas of logistics, labor regulations, and tax and tariff policies.
- Net gains to the economy. Being a net importer, India benefits from terms of trade improvement in case of currency appreciation. This is positive for domestic growth primarily as cost of imported commodities is likely to be lower, ceteris paribus. In India, inflation metrics have a varying impact of exchange rate changes. The CPI basket is less geared to the exchange rate fluctuations with most of the weightage being on food and services. We estimate that a 5% appreciation INR (against the USD) reduces long-run CPI inflation by 65 bps. The WPI inflation being geared towards manufactured products (weightage of around 65%) would be more sensitive to the exchange rate and have a more direct reflection. This price effect could be beneficial for consumption demand.