Indian Rupee Strengthens amid Dollar Decline but Oil Prices are Key to Outlook says ING

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- Economy in rude health but oil price to dictate INR outlook.

- 2018 price increase is fuelling rising supply of INR on markets.

- Currency faces more losses if oil prices climb further say ING.

The Rupee rose Tuesday amid a benign decline in the U.S. Dollar but respite from losses is likely to be brief and the outlook for the currency now depends heavily on the trajectory of oil prices, according to economists at ING Group. 

Tuesday's price action came as the U.S. Dollar declined and in the wake of a series of macroeconomic data points, including wholesale price and manufacturing production figures, that appear to show the Indian economy in rude health. 

However, the geopolitical environment is deteriorating in tandem with relations between the U.S. and some Middle Eastern countries, notably Saudi Arabia and Iran, which is threatening to drive oil prices even higher still.

"An oversold Indian rupee (INR) position since August provides the currency with an edge to outperform in a softer US dollar environment, though there is no lasting relief in sight due to persistently high oil prices," says Prakash Sakpal, an economist at ING Group. 

Oil matters for the Indian currency because it must be imported into the country and prices have surged by 22% so far in 2018. A possible diplomatic clash between the world's largest oil producer, Saudi Arabia, and the U.S. has provided impetus for the latest leg higher in prices. 

This has impacted the economy on the surface as well as beneath the proverbial bonnet. Higher prices have already lifted inflation and the level of imports, which tempered a still-impressive growth rate and may further hinder the economy as households begin to feel the additional strain on their incomes.

It has also got investors fearing a protracted deterioration of the current account balance, which measures changes in the amount of money flowing into and out of the country as well as movements in borrowing from the rest of the world.

Markets care about the data because it paints a telling picture of international demand for a currency while also providing insight into the extent to which a nation is exposed to changes in the sentiments of international lenders toward it.

The trade balance, which weighs the value of a companies imports against its exports, is one of many important components to the current account balance. 

"Oil imports have been falling on a month-on-month basis since July," says Sakpal. "However, after the recent spike in oil prices above $80 per barrel and with elevated geopolitical risk in gulf countries we anticipate no lasting relief on the trade deficit front. The cumulative deficit of $94 billion in the first half of FY2018-19 was still $20.7 billion wider on the year, supporting our view of a widening of the current account deficit to 2.6% of GDP in the current financial year."

The USD/INR rate has risen 15.4% in 2018, denoting a stronger U.S. Dollar and weaker Indian Rupee. The Pound-to-Dollar rate has gained 12.4%, despite Sterling also having declined against the Dollar, providing insight into the extent to which weakness in the Rupee has driven the move in the USD/INR rate.

With U.S. Dollar strength aside, the 2018 increase in oil prices explains the double-digit depreciation of the Rupee. This is because oil is priced in Dollars and when the cost of it rises, Indians must sell more Rupees on international markets in order to import it into the country. That then pushes Rupee exchange rates lower. 

"The four-day downward USD/INR streak last week was snapped on Monday, a sign that the markets aren’t taking much comfort from the better activity data. And we aren’t yet ruling out an intensified spillover from the recent high oil price on to the INR leaving our year-end USD/INR forecast at 76.5 (spot 73.8)," says Sakpal.

The USD/INR rate was quoted 0.68% lower at 73.26 Tuesday while the Pound-to-Rupee rate was 0.47% lower at 96.57. 

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