Indian Rupee Left Behind by Emerging Market Peers ahead of Crunch Reserve Bank Meeting

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- INR underperforms emerging market peers ahead of RBI meeting.

- Monday's RBI gathering to reveal if governor Urjit Patel will resign.

- Resignation means bond and INR sell-off says Capital Economics.

The Rupee weakened against the Dollar in the final session of the week as markets await a crunch Reserve Bank of India (RBI) meeting scheduled for Monday, which will reveal whether Governor Urjit Patel intends to resign or not.

Speculation about Patel's future at the bank has been rampant in recent weeks after it emerged the finance ministry has used a clause in the Reserve Bank of India Act 1934 to pressure RBI officials into changing bank regulations and handing "excess" foreign exchange reserves over to the government. 

RBI board members meet on Monday, although there is no interest rate decision scheduled, and local press have suggested Patel could resign in protest at what central bankers and the analyst community have described as a govermental threat to the institution's independence.  

India's Rupee weakened against the Dollar and other currencies on Friday, the final trading session before the meeting, while other emerging market currencies like the Turkish Lira and Argentine Peso strengthened against the greenback. 

"Our sense is that his resignation is unlikely, and there is every chance that the meeting will pass without incident. Nevertheless, the reports have raised the question of how markets might react if Governor Patel did walk away," says Shilan Shah, an economist at Capital Economics. 

Above: USD/INR (red and green) rate at one-minute intervals with USD/TRY overlay.

The Indian government is widely believed to be pressuring the bank to relax regulations designed to reduce the stock of bad loans washing around the financial sector.

It is also allegedly seeking to use the RBI's currency reserves to finance government spending ahead of an election due to take place in early 2019.

Bond and currency markets have a severe aversion to political meddling in the affairs of central banks given the risk that politically-motivated decisions can pose to financial stability and creditors of sovereign governments.

"It should not escape notice that the government’s positions – whether on easing credit to small firms or the RBI making larger transfers to the state – would tend to boost the economy at a time when it is already running into capacity constraints and when the RBI is trying to tighten policy," Shah says. 

Governments can easily be tempted to pressure central banks into keeping interest rates low for electoral reasons, but such decisions almost always gives rise to fears over the inflation outlook. This leads creditors to demand even higher rates than they otherwise would have when lending to governments.

"Governor Patel is considered a safe pair of hands and is on the more hawkish side of the spectrum. As such, his resignation midway through his tenure would most likely lead to a rise in bond yields and put downward pressure on the rupee," Shah explains.

The 2018 crisis in Turkey, which saw the Lira depreciate by as much as 60% at one point, demonstrates just how messy things can get when governments come through the back door to appoint themselves as de facto heads of a central bank.

As a result, markets will be watching the Reserve Bank of India closely on Monday. Market unease over the outcome of the meeting likely explains the Rupee's underperformance Friday.  

Above: USD/INR rate shown at daily intervals.

The USD/INR rate was quoted 0.09% higher at 71.97 Friday, denoting a weaker Rupee, and has now risen by 6.34% in 2018. It had risen as much as 16% during the 10 months to the beginning of November.

The Pound-to-Rupee rate was 0.64% higher at 92.40, denoting a weaker Rupee and stronger Sterling, and has gained 7.2% this year. It had risen almost 10% going into November.

Above: Pound-to-Rupee rate shown at daily intervals.

India's Rupee had been the worst performing Asian currency for 2018 up until early November, but it's pared losses against the U.S. Dollar rapidly this month as a confluence of factors have combined to relieving the currency from some of its heaviest burdens. 

Rising oil prices had lifted inflation and forced Indians to sell more Rupees on internationals market than they otherwise might have in order to pay for Dollar-denominated imports. So with Brent crude falling 15% from $80 per barrell in October to just $67 in November, oil prices are now up only 1% for 2018 and the Rupee has earned some respite.

Moreover, both U.S. and Chinese presidents are set to discuss a possible trade deal between the two countries at the G20 summit scheduled for month-end. This has nurtured a fledgling sense of optimism that the so-called trade war between the two countries can be de-escalated.

Signs of a U.S.-China detente have taken some of the wind from the safe-haven Dollar's sails and offered a break to all of the world's emerging markets, whose financial assets have been jettisoned from portfolios en masse this year due to fears of what an even stronger Dollar and a global economic slowdown might mean for developing economies.

"Based on just a couple of weeks of appreciation it's premature to judge that the worst is over," says Prakash Sakpal, an India economist at ING Group. "With tight liquidity depressing investment and the drag from net exports continuing to widen, GDP growth is poised to slow." 

India will release third-quarter GDP figures on Friday 30, November and economists anticipate that growth will have slowed during the three months to the end of September. Sakpal says growth will slow even further in the final quarter, and October's trade balance data released Thursday suggests he is right. 

Imports rose 17.6% to $44.1 billion that month, leading the trade deficit to widen from -$13.9 billion in September to -$17.1 billion in October. Imports are a subtraction in the calculation of GDP. 

"We have revised our end-2018 forecast for USD/INR from 76.5 to 74.0. However, the potential escalation in the political uncertainty amid legislative assembly elections in five states this month, and in the run-up to the national elections in May 2019, will sustain the weakening bias on the INR. We continue to see the USD/INR rising past the 75 level against the USD in the next three-to-six months," Sakpal writes, in a note to clients on Tuesday.

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