The Indian Rupee is Still Vulnerable says Bank of America as Others Eye Central Bank Support

© Natanael Ginting, Adobe Stock

- Oil prices to widen current account deficit and stoke inflation.

- Both likely to command a weaker Rupee says Bank of America.

- But Reserve Bank will step in to temper decline say other analysts. 

The Rupee begun the new week on its back foot and will remain vulnerable to losses going forward, according to some analysts, but fresh action from the Reserve Bank of India (RBI) could help temper the decline. 

India's Rupee has been badly damaged in 2018, despite robust levels of economic growth, due to the impact the rising oil price has had on supply of the currency on global markets as well as the nation's current account deficit. 

A 20% rise in the price of Brent crude oil helped India's current account deficit widen to -$15.8 billion during the second-quarter, or 2.4% of GDP, from -$14.9 billion one year ago.

But half the oil price rise has materialised since the end of June and so too has almost all the Rupee's double-digit 2018 devaluation against the U.S. Dollar.

This means much of the adverse impact from this year's events is yet to actually be felt by the current account deficit, suggesting the Rupee could be further undermined once the rest of the impact does become apparent. 

"The Indian Rupee, Indonesian Rupiah and Chinese Renmimbi have all weakened substantially due to clear and present local risks. For INR and IDR, current account deficits and a revealed policy preference to tolerate weakness (but control volatility) means that risks remain for further depreciation," says Ardash Sinha, a strategist at Bank of America Merrill Lynch.

The current account measures changes in the amount of money flowing into and out of India as well as movements in borrowing from the rest of the world.

Markets care about current accounts because they paint a telling picture of international demand for a currency while providing insight into the extent to which a nation is exposed to changes in the sentiments of international lenders.

The deficit has widened as Indian sell greater numbers of Rupees than before in order to pay for costlier imports and to service foreign currency debts, which have also become more expensive in light of 2018's depreciation. 

But the impact stemming from 2018's commodity price movements and a rampantly strong U.S. Dollar does not stop there. 

"The RBI has stepped up its intervention in both spot and forward FX markets since April 2018," says Kanika Pasricha, an India economist at Standard Chartered. "During the second week of October, we estimate that the intervention was heavier in the spot market, though we will watch whether this trend is sustained."

The downward pressure on the Rupee has been so great that the sell-off has persisted despite the Reserve Bank of India having sold an estimated $25 billion during the second quarter alone. This is equal to 5% of the RBI's $420 billion foreign exchange reserves. 

The RBI has sold foreign currencies and bought back the Rupee in an effort to defend it from the effect of its own citizens' commercial activity as well as from speculators, who have bet against the the currency this year in the hope of profiting from the adverse impact a surge in U.S. interest rates has had on the emerging world.

"We believe that the move indicates policy makers’ intent to reduce risks to financial markets both from external and domestic factors. Further action cannot be ruled out. However, intervention at a similar pace is unlikely to be sustained, in our view, unless the global/domestic backdrop deteriorates significantly. Oil will remain a key determinant of external-sector balances," says Pasricha. 

More weakness in Rupee exchange rates will also stoke inflation. So far inflation has fallen in 2018, from 5.07% in January to 3.77% in September, but this has been due to a decline in food prices.

Core inflation, which removes food and energy prices from the goods basket, rose from 5.1% in January to 5.81% in September. It was reported above 6% in May and June 2018. 

The RBI is required to keep inflation at 4%, plus or minus 2% in either direction, over the medium term. And while both inflation measures have fallen back of late, households' inflation expectations have been rising. 

Dr Chetan Ghate, an RBI interest rate setter, was revealed on Friday to have advocated for additional interest rate rises from the RBI in order to contain the recent pickup in the number of households anticipating an increase in prices.

"What makes these cumulative increases in inflationary expectations salient, is that they risk being unanchored by both the 7% nominal depreciation in the INR and the USD 13 a barrel increase in the price of oil, since the August 2018 policy statement," says Ghate, in the MPC's latest meeting. "My own projections with the above variables suggest that these factors will push inflation beyond the Q1 FY19-20 projection of 4.8% made by the RBI."

Ghate spoke in the meeting about what he says is a need for the RBI to retain its credibility with the market as an inflation-fighting central bank. He advocates more rate hikes from the central bank, which has already lifted its deposit rate by 50 basis points to 6.5% in 2018. 

If Ghate gets his way then RBI policy could offer support to the Rupee during coming months because although changes in rates are only normally made in response to movements in inflation, they impact currencies significantly because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

"The minutes to the October meeting (released on Friday evening) suggest that concerns about underlying price pressures continue to linger," says Shilan Shah, an economist at Capital Economics. "We think that the swiftness with which the RBI has already responded to the recent rise in inflation will help to anchor inflation expectations and prevent the need for aggressive policy changes in the future. But we don’t think its work is fully done yet. We are forecasting one more 25bp increase in the repo rate to 6.75% in this cycle."

The USD/INR rate has risen 15.2% in 2018, denoting a stronger U.S. Dollar and weaker Indian Rupee. The Pound-to-Dollar rate has gained 10.6%, 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.

The USD/INR rate was quoted 0.25% higher at 73.55 Monday while the Pound-to-Rupee rate was 0.53% lower at 95.35.

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