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Asiamoney FX report, February 2012

India’s currency was one of the weakest in the region in 2011. From 44.7 rupees to the dollar at the end of 2010, it dropped to 53 by the end of 2011, hitting a low of 54.30 during December – and this in a year in which most Asian currencies were resilient. Coupled with a stock market that plunged 25% through the year, it all made for a miserable experience for foreign investors into the country; in dollar terms, for equity investors, it was one of the worst performing emerging markets in the world.

The temptation is to wonder why the rupee did so much worse than the rest of Asia, but strategists tend to resist this, saying that India marches very much to the beat of its own drum.

“The selloff of the INR looks pretty violent in the context of regional currencies in Asia,” says Rahul Bajoria, chief economist for the region at Barclays Capital. “But that’s the wrong comparison.” India is the one country in the region with a large current account deficit; the rest of the region is instead characterised by surpluses. “It’s important to make that clarification straight up because that makes the INR very susceptible to shocks,” Bajoria says. “Capital flows have a bigger impact on INR than other currencies.”

Instead, Bajoria says, the better emerging market comparisons are nations like Brazil, Turkey, South Africa or Hungary, all of which run current account deficits and, like India, have a sharp dependency on capital flows. “In those countries, you saw a similar move,” he says. “Relative to the dollar they all saw around a 15 to 20% move. It’s better to compare India against them rather than, say, Korea or Taiwan which are a different situation completely.”

OK; but even if India didn’t plunge in isolation, that doesn’t alter the fact that it most certainly did plunge. So what next? Is it going further down? The positive view is that the worst is over. “The rupee surprised everyone by how much it weakened,” says Nadir Mahmud, Asia head of foreign exchange and local markets trading and risk at Citi. “Now the rupee is probably going to track most of the Asian currencies.

“The big issue with the rupee is what they are doing on the fiscal side,” Mahmud says. “But we don’t think it’s going to be an underperformer with respect to other Asian currencies, at least not from where it’s valued at this point in time.”

In fact, at this very early stage of the year, the rupee has been one of the better performing currencies in 2012, partly driven by an expiry of auction limits that prompted investors to buy bonds, thus driving inflows. At the time of writing, it had rallied to 50.25 to the dollar. The government and Reserve Bank of India have taken measures to steady the currency and reduce volatility, such as deregulating interest rates on deposits, which some analysts believe could lead to US$4-6 billion of inflows, helping with the current account deficit. It has also conducted what it calls open market operations in order to steady its bond markets, and has opened equity markets to direct participation by foreign institutional investors. “The currency has stabilised and it’s easier to hedge your positions, which makes life easier for exporters and importers,” says Bajoria. “It’s not like you don’t know if there’s going to be a 20% sell-off.”

[subhead] Can’t get worse?

Mahmud’s argument – it’s fallen so far it’s unlikely to fall further – makes a certain amount of sense, particularly in light of this spritely start to the year. As Bajoria notes: “There was some overvaluation, and that has been removed.” But actually there’s quite a widespread view that things could get worse before they get better. “Our expectation is it continues to underperform in the short term,” says Bajoria. “Liquidity in the market has started to dry up, and that opens up room for one-way moves to become exaggerated.” HSBC and Bank of America Merrill Lynch raise the prospects of significant further declines, discussed in more detail below.

Underpinning the performance of the currency, and its outlook, is the state of India’s fiscal position. For much of last year, attention was closely focused on inflation. This has a big impact on the currency because it has had the effect of making real interest rates in India deeply negative despite high nominal rates; that makes deficit financing more difficult and in turn weakens the currency. HSBC argues that India has the greatest inflation pass-through from the exchange rate in all of Asia, despite a relatively closed economy. The worry is that a continuing depreciation of the currency simply makes inflation worse, and creates a cycle.

The Reserve Bank appeared to have thrown a lot at this problem with little effect through 2011; there were worries that it was running out of firepower. But fortunately, the latest inflation figure, for December, was 7.5%, down from 9.1% the previous month and 9.7% in October. While high by regional standards (ignoring outliers like Vietnam), it is an improvement, and not a moment too soon; any sense that it was no longer in the RBI’s power to keep a lid on inflation would have led to a widespread loss of confidence with the potential to affect all asset classes.

Now, analysts have started calling a rate of 7% by March. “Inflationary pressures have moderated,” says Bajoria, who expects inflation to “remain quite sticky” in a range of 5.5% to 7% over the next 12 to 18 months. But he warns: “The RBI is going to be cautious about completely declaring victory over inflation, because they’ve been burned before.”

If you believe that inflation is under control, then it becomes logical to talk about rate cuts, and indeed more and more houses are expecting them – some as early as January [RICHARD: RBI meeting is Jan 24 so we will need to keep an eye out]. Bajoria expects cuts to start in April. Bank of America Merrill Lynch expects 100 basis points of cuts from March to July. That is likely to have a number of knock-on effects if it helps to drive growth, and would likely support the currency.

[Subhead] The deficit

Beyond that, there is a tendency among commentators focus on the current account deficit, though some analysts say that may be overdone. “There is an issue with placing too much emphasis on the size of the INR’s current account deficit,” says Paul Mackel, head of Asia currency research at HSBC. In fact, India’s deficit, at 3% of GDP, is much lower than Turkey’s at 9%, for example, yet the Turkish lira has not been so badly hit lately. “It is not the size of the current account deficit alone which is driving the currency lower.”

So what is it? Apart from inflation, Mackel raises two other points in particular: an increasing dependency on external debt; and FX policy.

On the first, Mackel notes: “A current account deficit, regardless of its size, is not a currency issue if it can be comfortably and reliably financed.” The problem is, with India, that comfort is not really there as US dollar liquidity has tightened. Net portfolio inflows for much of 2011 were subdued, with FDI flows weaker in the second half of the year in particular. That’s not really India’s fault – more a function of global macro problems and a risk-off attitude to international capital – but “with a substantial weakening of these two key pillars of current account deficit financing, an increasing burden shifted to other funding,” and in particular external debt. That’s a problem when funding markets dry up, as they started to do late last year, and puts the pressure on FX reserves.

Then there’s policy. In December Mackel, clearly attempting to be polite, wrote: “The RBI’s recent FX policy might be described as benign neglect by some.” He means that the RBI, at least through 2011, didn’t seem to be resisting the weakness of its currency, presumably to make it more competitive and to help exporters, rebalancing external accounts. On top of that, Mackel thinks the Reserve Bank hasn’t intervened because it wants to preserve its FX reserves. “Asian FX policy when under depreciation pressure often faces a trade-off between safeguarding confidence over FX reserve adequacy, and preventing too disorderly a deprecation.” The risk – and the RBI has expressed this itself – is that you can put a chunk of your reserves into the market but end up facing exactly the same pressures, only now with a lower cushion.

(It should be noted that Mackel’s comments came before a release of data from the RBI which showed it made its biggest dollar sale intervention in almost three years in November, and also intervened in the two previous months.)

[Subhead] Still not cheap?

The combination of these factors leads Mackel to conclude that the rupee is still not actually all that cheap. Looking at real effective exchange rates, HSBC only has the rupee at fair value and in line with long-term averages – on this calculation, the reason the rupee fell so badly is because in early 2011 it was 15% overvalued. And it could get worse before it gets better: in December HSBC outlined a case in which it could fall to 58 against the dollar. The bank’s recent currency outlook ranked the rupee among the worst candidates for performance in 2011, adding concerns about non-performing loans and FDI potential FDI policy reversals to the mix of drags that Mackel outlines.

58 is a very bearish case, but Mackel’s not alone in seeing a risk for further deterioration. Claudio Piron, emerging Asia fixed income strategist at Bank of America Merrill Lynch, says in a January report the rupee is “vulnerable to a downside of 55 against the USD in 1Q,” although he expects outperformance and a rally to 52 after that.

After all, there are also other risks that India can’t control. The most obvious point is that if the US dollar has an excellent year, then naturally the rupee may decline no matter how India’s fiscal position looks. On top of that, there are uncertainties everywhere, from commodity prices to eurozone debt. “If oil prices were to go up for any reason, we have a problem,” says Bajoria. And there’s no ignoring the macro picture and the potential for a worsening situation in Europe. Craig Chan at Nomura argues that India, along with Korea and Indonesia, are the most vulnerable in the region if deleveraging accelerates as a consequence of problems in Europe. “Significant uncertainty and the risk of capital flight post most risk to India and Korea with financing gaps to reserves at -43% and -32% respectively,” he says, using Nomura assumptions for those numbers.

The whole debate seems some distance from the ardour that until recently surrounded this BRIC founder member. It was only in November 2010 that the Sensex was touching all-time highs over 21,000 points, levels it lags by 5,000 points today; a combination of global worries, inflation and fiscal trouble appear to have weakened the country and dampened its outlook. But nothing has ever involved an upward straight line here, and the demographic picture of over a billion people accumulating wealth and education remains intact. That will always underpin strength in the currency, with the biggest question how it soars and dives along the way.

[Box]Equity flows?

In January, new rules permitting foreign institutional investors to invest directly in local stocks, rather than through funds, attracted some fanfare, and hopes of new inflows with a consequent strengthening of the rupee. But economists are cautious. “It’s going to take a while before we see any strong impact,” says Rahul Bajoria, chief economist at Barclays Capital. “This is a new regulation, so even if people want to directly participate they will have to figure out the guidelines. They are not going to jump in right away.”

That said, Bajoria thinks a “possible turning point” could be if the Reserve Bank starts cutting rates. “That’s going to be seen as a positive for the equity market, because in India’s case, interest rate differentials don’t work so much in favour of capital inflows.” Instead, lower interest rates improve the outlook for manufacturing and services, and therefore the stock market.

Chris Wright
Chris Wright
Chris is a journalist specialising in business and financial journalism across Asia, Australia and the Middle East. He is Asia editor for Euromoney magazine and has written for publications including the Financial Times, Institutional Investor, Forbes, Asiamoney, the Australian Financial Review, Discovery Channel Magazine, Qantas: The Australian Way and BRW. He is the author of No More Worlds to Conquer, published by HarperCollins.

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