Indian rupee’s overvaluation and ample buffers
- Improved BOP has kept the INR steady against the USD, pushing up the real exchange rate
- Appreciation would have been greater if the RBI had not intervened vigorously
- Based on our currency valuation model, the INR is modestly overvalued
- Ongoing structural reforms could help competitiveness metrics…
- … offsetting the risk stemming from an overvalued currency
As the Fed begins to consider asset purchase taper and eventual policy normalisation, there is considerable concern that emerging markets are ripe for another dislocation. Should we worry about the INR again?
There are compelling reasons to argue that the rupee can be counted out of the fragile pack this time. Also, circumstances are rather different this time. Unlike 2013, when growth was slow relative to trend, it was nothing like the deep contraction of recent quarters. Currencies associated with sticky inflation and negative real rates due to economic ought to be facing depreciation pressure, but it has been the opposite thus far, owing to a marked improvement in the balance of payments. Indeed, despite the ongoing economic malaise, rupee would have appreciated substantially had the RBI not intervened vigorously.
The prevailing peculiar juxtaposition of a weak economy and strong currency need not sustain. Indeed, we see the dynamics of a gradual depreciation path.
Surge in capital flows
Two developments have propped up India’s balance of payments – a healthier current account balance and strong portfolio/ investment pipeline.
Firstly, the pandemic-led softer domestic demand resulted in import compression last year, which alongside soft commodity prices will lead to a current account surplus (DBSf: 1.1% of GDP) in FY21. Into FY22, as the economic impact of the second wave ebbs and commodity prices rise (particularly crude oil), the current account deficit is likely to return, albeit by a smaller measure – FY22 gap to USD20bn (-0.7% of GDP), half of the pre-pandemic gap.
Second, portfolio and investment flows were at multi-year highs in FY21, notwithstanding the pandemic. Foreign portfolio inflows into equity surged to USD37bn, even as flows into debt were lacklustre (-USD4.6bn). Concurrently, gross FDI inflows were at a record high of USD81.7bn, lifted by a great extent by investments into new subsidiaries of the country’s biggest conglomerate. Net FDI inflows were USD54.7bn.
Some of this strength is likely to spill over into FY22. After a hiatus in Apr-May, foreign equity investors returned in June with over USD2bn inflows. FDI flows for the Jun quarter has also started on a strong note with USD4.6bn in April. From an estimated USD95bn BOP surplus in FY21, the FY22 balance is likely to halve but register a strong USD45bn.
The basic balance of payments (basic BOP) i.e. current account plus FDI is also expected to stay positive, signifying a healthy flows pipeline.
Consistent FX reserves accumulation has been a key tenet of the Reserve Bank of India’s (RBI) framework to ensure stability in the financial markets. India’s reserves stock is the fourth largest in the world at a record high of USD608bn, behind China, Japan, and Switzerland. India’s reserves are the second highest in Asia, up USD140bn since 2020. We expect Indian markets to be partly de-risked owing to the high foreign reserves stock as well as improved adequacy, just as the discussion on timing of the US taper tantrums gains traction.
• Amongst conventional ratios, imports coverage is high at 12-13x, doubling from levels during the 2013 taper tantrum.
• Ratio of total external debt now accounts for 0.9 of reserves vs 1.4 in 2013, with short-term obligations (original maturity) at 0.17 vs 0.34, respectively, displaying lower vulnerability. The current stock fares well on the IMF’s ARA framework as well
In wake of sustained capital inflows, the RBI has acted to maintain a stable-to-weaker rupee. As dollar purchases inject primary rupee liquidity (if left unsterilised), specifically owing to spot market operations, the RBI has been active in the forwards space which will impact liquidity with a lag i.e. when the transactions mature and aren’t rolled over.
Official data shows that for nearly two years to Jul20, the RBI held net shorts in INR forwards, before switching to long positions, which has taken the net forwards to a fresh peak of USD73bn in Feb21 before easing over the next two months (latest data available).
Tenor-breakdown shows that majority of these forwards are parked in the less than one-year bucket. Strong presence in the forwards markets has not been without impact, as forward premiums have consistently risen, especially in the 3M contracts, which in turn deterred importers from hedging their currency exposure as well as slowing interests into the debt market.
The authorities have changed tack lately. The intensity of intervention in forwards has eased off, as evidenced by a fall in forward premia as well as a pullback in the total net forward contracts, suggesting the RBI is opting not to rollover rather take delivery. This decision may have been influenced by an unexpected quickening in inflation as well as need for cheaper hedging costs that temporarily upstaged liquidity considerations. Still, the RBI is likely to maintain presence in the spot markets to guide the currency, in conjunction with liquidity-absorption tools e.g. market stabilisation bonds (MSS).
As they continue to juggle multiple objectives, the objective will stay responsive to change in priorities, which implies that during occasions of high inflation, pockets of INR strength might be tolerated. Beyond such occasions, the overarching bias will be to keep the rupee on track for gradual depreciation.
Reserves accumulation strategy
Even as total reserves are at record highs, we see reasons for this accumulation to continue.
• DBS gauge of reserves to global external financing requirement ratios for India, along with Indonesia and Malaysia, are amongst the smallest vs the regionals, underscoring the need for better buffers
• Rising foreign reserves co-exist with a net negative international investment position (IIP). This balance shows the value of financial assets of residents of an economy that are claims on non-residents and stands at -USD340bn by end-2020 (-12.9% of GDP).
Reserve assets account for 68% of the total IIP assets (see chart). This imbalance is likely to keep the central bank keen to further strengthen the buffer, also providing a key ammunition to fight-off short-term volatility in global developments. – see chart
The June RBI post-policy commentary pointed to an elevation in reserves accretion as a priority for the central bank, not merely conjoined with the FX movements. To establish whether there is a specific threshold in mind, we are of the view that in addition to the above two factors that make a case for further buffer, the authorities likely see it necessary to strengthen this cushion at least for the duration of the ultra-loose global policies, which have translated into strong inflows into EM assets, including India. Upcoming US Fed taper and hiking cycle thereafter will test the markets’ defences.
India sharpened its focus to boost its manufacturing sector last year as we discussed in Understanding India: Manufacturing push – a reset, with a competitive currency to complement this push. While rupee’s historical moves vs key trading partners (particularly China) do not display material benefits from currency movements, official preference is to keep the INR aligned to regional FX movements and cap volatility.
On real effective exchange rate basis, the rupee depreciated beyond one standard deviation from the 10Y average back in 2013, but that has since corrected, and is hovering around the neutral mark since the pandemic.
Having built fairly strong buffers, the other option available to Indian authorities is to pursue structural reforms that solidify the attractiveness of Indian assets. This would include improvement in the investment environment, enhancement of physical and human capital, and support for modernisation of various sectors in the economy. These would enhance productivity and real returns on capital, keeping foreign capital destined for India. Ongoing structural reforms could help India’s competitiveness metrics, offsetting the risks stemming from an overvalued currency.
Few risks to keep an eye on which could trigger abrupt weakness in the currency include, a) sharp current account deterioration if growth recovers strongly without commensurate supply/ capex growth and commodity prices (particularly crude oil); b) hefty bond purchases program which might be construed as debt monetisation, just as overall debt levels jump; c) strong USUSD rebound owing to faster than anticipated pace of US Taper; d) flows exhibit volatility due to shifts in global policies; e) uncertain Covid-19 situation.
To ascertain if the INR is misaligned from long-term fair value, we calculate its valuation and compare it against its peers In a nutshell, the DBS Equilibrium Exchange Rate (DEER) model factors in a country’s productivity and terms of trade differentials against its trading partners to derive long-term exchange valuations. DEER valuations are calculated with the following equation:
INR looks over-valued based on its DEER fair value, and also ranks as more expensive compared to regional peers such as CNY and IDR. Its small over-valuation (+5%) is likely due to sizable foreign equity inflows, which have reached a cumulative USD8bn year-to-date.
Despite INR’s overvaluation, it is by no means as expensive as where it was in 2017, when USD/INR reached record lows. For one, INR DEER valuation looks attractive relative to the USD (unlike 2013), and this should help to restrain against a surge in USD/INR. Furthermore, India’s external financing needs today have fallen due to a smaller trade deficit, while FX reserve buffers have also increased significantly. INR risks should thus be contained.
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