India: rupee down but watch out for a sudden reversal * JPMorgan

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India: rupee down but watch out for a sudden reversal

After demonstrating remarkable resilience over the last year, the INR has depreciated almost 12 percent over the last two months While the INR significantly underperformed the region on account of local factors in August, it has moved in tandem with the rest of the region in September, despite heightened global risk aversion INR weakness is likely to persist in the near-term as global risk aversion stays elevated, India’s export growth finally moderates and imports remain buoyant in an economy that is slowing only gradually But the balance of payments fundamentals remain supportive as India’s projected current account deficit for this fiscal can be financed by making relatively conservative assumptions on capital flows With global pessimism expected to assuage in the coming months, the rupee is likely to revert to around USD/INR 45-46 by December 2011 and 44-45 by March 2012, consistent with previous INR crashes reversing quickly   Resilience comes to an end   Contrary to conventional wisdom, the INR demonstrated remarkable resilience for much of the last year. To fully appreciate this, consider the following: India imports more than 80 percent of its crude requirements. The Indian crude basket jumped more than 50 percent between July 2010 and July 2011. Despite this, however, the INR actually appreciated almost 5 percent during that time, as India’s exports surged and the trade deficit compressed sharply.   However, that resilience has come to an end over the last 6 weeks. Starting August 8, the Monday after US Treasuries were downgraded, the INR began to under-perform the region. As global risk aversion has risen in recent weeks, pressures have built up and came to a head over the last week. The USD/INR depreciated almost 5% over the last week, one its worst performances in 18 years, and is now trading at its lowest level since May 2009.   A half truth   The INR’s sharp depreciation and the fact that it began to depreciate sooner than other Asian currencies may give the impression that it has consistently underperformed the region over the last two months. That is only half true.       The INR significantly underperformed the region (ex CNY and HKD) in August. The reasons were manifold. Domestic trade fundamentals worsened in August (the trade deficit rose to $14 billion from $11 billion the month before) as India's sizzling export run finally began to moderate. Meanwhile, import growth remained healthy as, contrary to conventional wisdom, the economy only slowed gradually and domestic firms continued to indulge in import substitution to take advantage of the inflation differential between India and her trading partners. This was exacerbated by a one-off $5 billion of oil payments to Iran. As a result, the currency depreciated almost 5% that month even as the downward move of other Asian currencies was far more muted. All this was compounded by the fact that the INR is a “high-beta” currency – historically underperforming the region in times of global stress, as investors worry about the financing of its current account deficit, in contrast to the current account surpluses of its neighbors.   That said, the INR’s performance in September is a completely different story. The trade fundamentals likely did not improve in September and global stress has increased in recent weeks (implying that India’s high-beta characteristic should suggest increasing underperformance). Despite that, however, the currency has held its own over the last month, moving broadly in tandem with other Asian currencies (ex HKD and CNY), suggesting that global, not domestic, factors have been responsible for the INR’s recent trajectory.   Weakness could persist in the near-term   The key question, however, is whether the weakness will persist or whether the INR will quickly mean-revert, as has been the case in the past.   With India’s trade and current account deficit unlikely to compress sharply anytime soon, rupee weakness could persist if global risk aversion were to remain elevated. With new export orders within the PMI trending down for a while, export growth is likely to moderate further. Meanwhile, while the domestic economy slows, it is doing so very gradually. As such, it is unlikely that import growth is going to collapse, even if the 10% depreciation of the rupee in recent weeks has negated the inflation differential between India and her trading partners. As such, until India’s economy slows further and imports moderate further, the current account deficit is likely to get worse before it gets better.         The fact that the INR has moved in tandem with the rest of Asia over the last few weeks suggest that India is still able to attract the capital flows to finance the current deficit, with external commercial borrowings (ECBs) and trade credits constituting the bulk of capital flows over the last few months. However, sustained global stress could result in these flows becoming relatively scarce. Add to this, the negative sentiment that accompanies the INR in times of global stress and near-term INR weakness is likely to sustain – reflected in the fact that the perceived likelihood of a further depreciation on the part of investors has recently increased         Where is the RBI?   The sharp depreciation of the INR in recent weeks has effectively loosened monetary conditions (by increasing the domestic price of tradables) and thereby undercutting the central bank’s monetary tightening efforts, leading market participants to expect that the RBI would step in to stem the depreciation.   Belying expectations, however, the RBI has not intervened in any significant manner or expressed an interest to target a certain level, in keeping with its hands-off approach from the FX market and recognizing that this is a region-wide sentiment and one that will be difficult or very costly to counter.   Will the RBI draw a line on the sand? Not based on their behavior over the past three years. The RBI tends to intervene only when it believes the intervention will be effective. Against the wave of global pessimism the RBI is unlikely to do so.         But BoP fundamentals remain supportive   Near term weakness, notwithstanding, the underlying BoP fundamentals are still supportive of an INR appreciation when global stress abates.   As alluded to above, with export growth likely to moderate, and import growth still healthy, the trade and current account deficits are likely to widen in FY12. That said, sustained and elevated global risk aversion is likely to depress commodity prices limiting the extent to which the CAD widens in such an environment.   Our BoP projections below assume that export growth for the full year will only be 12 percent, significantly below the current run-rate. We, therefore, have assumed that exports are likely to taper off significantly for the rest of the fiscal. We are similarly conservative on the trade deficit, assuming that the trade deficit widens further to the $15-16 billion for the rest of this year – levels that were last seen in the run-up to the Lehman crisis. If anything, the CAD is therefore likely to surprise on the downside.   The key, however, will be capital flows. Even if FDI flows are very anemic over the next few quarters, the pick-up in FDI in the last quarter in conjunction with the recent passage of the BP-RIL deal should ensure a pick-up in FDI flows for the full-year compared to the last fiscal.   With policy rates continuing to be raised in India and tight banking system liquidity keeping market rates high, the onshore-offshore interest differential has continued to widen, inducing corporates to borrow offshore. This run-rate has picked up significantly in recent months, and is likely to sustain once global stress settles. With trade flows expected to moderate but still remaining relatively buoyant – trade credits are also expected to be a source of flows, unless global conditions worsen further. While FII equity flows remain the joker in the pack, debt flows have been relatively steady this fiscal and are expected to get a boost with the recent relaxation of norms for FIIs interested in infrastructure bonds.   Thus far while FII flows are under-performing our projections, this has been offset by the fact that external commercial borrowings (ECBs) (currently tracking $3 billion a month since the start of the fiscal year) are significantly above our projections.   In sum, relatively conservative assumptions on capital flows are required to finance the projected CAD for FY12, unless global risk aversion remains at a level that is not conducive for EM assets.   Rupee’s sudden reversals and exporters   Since the Lehman crisis, the INR has crashed twice and in both instances has reversed in 2-3 months once global risk aversion has dissipated. In each case, domestic exporters appear to have played a key role both in the crash and in the reversal. Typically as the rupee starts depreciating, given the widely held but empirically unsubstantiated belief that a current account deficit currency must depreciate, exporters delay converting their earnings to increase their rupee returns. The lack of supply turns the market relatively illiquid and one-sided pushing even modest depreciation into free falls. Once exporters start believing the bottom has been reached either because of a turnaround in global sentiment or (in the unlikely event) of the RBI supporting a level, they return with vengeance to avoid losing any of the windfall gain. The sudden surge of the FX selling sends the rupee in a sudden appreciating reversal.   As such, we expect that with global pessimism assuaging in the coming months as Europe works out a solution to its debt and bank recapitalization problems, the rupee is likely to revert to around USD/INR 45-46 by December 2011 and 44-45 by March 2012.