The Indian rupee slipped beyond the multi-year support of 69 and now trades near 71 levels on the back of a broader emerging market (EM) currency selloff and rising crude oil prices. To understand what led to this depreciation and where the currency is headed it is important to understand the global factors involved.

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In the US, GDP for the last quarter was upwardly revised to a robust 4.2% (from 4%) and the current quarter’s growth is expected to be around a strong 3%. The higher frequency US data continues to outperform other developed market economies and with inflation at 2.9%, there does not seem to be any reason why the Federal Reserve Bank would pause on the rate hikes or deviate from its path of balance sheet reduction. Along with this tightening of dollar liquidity, the US rhetoric on trade with China is proving to be negative for yuan and other emerging market currencies. Therefore in this global context, there does not seem to be any visible reason for a broad-based dollar weakness in the near future. Mid-term elections in the US (November 6, 2018) could lead to political turmoil which could lead to a selloff in the greenback, but that is some time away.

In the emerging country space, the US-Turkey diplomatic crisis has proved to be a catalyst for the markets to test currencies with a high current account or fiscal deficit. This has triggered a broad-based sell-off in EM currencies led by the Turkish lira, South African rand, Argentinean peso and also to a certain extent the Indian rupee. Chinese yuan depreciated sharply from 6.4 levels in June to 6.85 currently on account trade concerns with the US. In each of these cases, the reason for local currency depreciation has been different but the overriding factor leading to the pressure is increasing US rates and decreasing dollar liquidity.

Given the above construct, the fact that Brent oil prices jumped from 70 to 78 levels in a matter of two weeks accompanied by EM currency sell-off has not helped the rupee. Policy makers had most likely defended the rupee aggressively at 69 levels but in the wake of other EM currencies losing ground against the dollar, it seems they have resorted to a hands-off approach now. It could be that the policymakers want to use this opportunity to generate the one-time depreciation in rupee which would correct the overvaluation in reer terms. According to our estimates, dollar-rupee would be fairly valued in reer terms around 72.50 levels.

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Rising crude oil prices and increasing electronic imports creates concerns on India’s trade deficit (for July 2018 the deficit was at a five year high of $18 billion). Coupled with the anticipation of further fiscal slippages in a pre-election year, we could see limited foreign institutional investor (FII) inflows into debt and equity markets, making the financing of current account deficit a worry. Therefore in spite of an economy growing at a robust pace and an inflation number hovering around the target 4%, the rupee can come under further pressure. For the week ahead, rupee can be expected to not appreciate beyond 70.40 while 71.25 could offer significant support.

By, Rajat Monga
(The writer is senior group president, financial market, YES Bank)

Source: DNA Money