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An Orderly Correction In The Rupee Is Just What The Doctor Ordered

The Indian currency has slipped to its weakest levels in about six months, closing at 65.45 per dollar on Tuesday. The rupee, which has been on a declining trend since September 10, has fallen about 2.5 percent over this period. The weakness has been persistent, but it has not been disorderly. Market participants say the Reserve Bank of India has remained mostly on the sidelines, suggesting that there hasn’t been significant volatility since the Indian central bank typically steps in to smoothen out extreme movements.

While there are a number of immediate triggers for the change in the currency’s direction, it is essentially a correction of the outperformance seen in the Indian rupee earlier this year and last year. The rupee, which was one of the best performing Asian currencies in the last fiscal year, continued to gain in the early part of this year. Even during periods of strength in the dollar index between March and May, the rupee had diverged and continued to strengthen. The reason was strong inflows into the debt market. The steady appreciation had led to concerns about the currency getting overvalued on a real effective exchange rate basis, which in turn was seen as one reason for the decline in export growth.

What we are seeing now is a reversal of that trend with the rupee weakening even though the dollar has remained mostly steady.

Month to date, the Indian currency is the worst performing in Asia and has slipped 2.3 percent. September’s weakness has also brought down the rupee’s ranking in terms of its year-to-date performance. The rupee is up a moderate 3.87 percent so far this year. This is much lower than the 8 percent surge on the Thai baht, the 6.7 percent gain on the Taiwanese dollar, and even lesser than the 4.7 percent rise in the Chinese yuan.

Currency market participants do not expect the correction to extend much further. Bhaskar Panda of the treasury advisory group at HDFC Bank told BloombergQuint that technically, the rupee will see support at its 200-day moving average of 65.51 against the U.S. dollar. The depreciation is a healthy correction, Panda said.

Fundamentally too, most analysts are holding on to their year end call. Mitul Kotecha, head of foreign exchange for Asia at Barclays told BloombergQuint on Friday that the firm expects the rupee to strengthen towards the end of the year.

Mitul Kotecha, Head - Foreign Exchange, BarclaysWe are still constructive on the rupee. The rupee is still one of the best carry currencies among emerging economies. We think there could still be flows into India, although admittedly not on the debt side. Hard to see this turning into a rout for the rupee. 

There may be limited risk of a sharp correction on the currency, but policymakers would still do well to take note of the triggers that have led to this correction.

The limited head room for foreign inflows into the debt markets had kept the currency in a narrow range, but what sparked off the weakness was talk of a fiscal stimulus. Weakness in growth has led some commentators to suggest the need for additional government spending, in a year when government revenues are unpredictable due to the implementation of the Goods and Services Tax. Top government officials have kept their cards close to the chest but have not publicly denied the possibility of breaching the 3.2 percent fiscal deficit target for the year. This has left markets nervous and everyone is now focused on the negatives rather than the positives, said a currency market trader speaking on the condition of anonymity.

Among the negatives is the widening current account deficit and the slowdown in portfolio inflows. The current account deficit hit a four-year high of 2.4 percent of gross domestic product in the April-June quarter. For the full financial year, Kotak Institutional Equities now expects a current account deficit of 2 percent of GDP, the research house said in a report on September 20. Fund flows, meantime, have slowed to a trickle.

In September, debt and equity markets together have seen an outflow of Rs 1,335 crore.

Concerns about overvalued equity markets could keep equity flows thin. In the debt markets, though, some additional headroom for flows has been created by moving masala bonds out of the corporate bond limit. This will allow another Rs 44,000 crore to flow into corporate bonds over two quarters, although some part of this limit is reserved for long term investment in infrastructure bonds.

The final risk factor that cannot be ignored is oil, with Brent crude prices are trading at the highest level since July 2015. The relationship between oil and the rupee has not always been straight forward, but in a scenario where India’s twin deficits are not looking as comfortable as they have been over the past couple of years, higher oil prices will be negative for India’s public finances and the rupee.

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

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