The Indian Rupee will Overcome Election Test, is a "Top Trade" for 2019 at Morgan Stanley

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- Improving fundamental outlook for INR overshadowed by elections. 

- Politics to constrain recovery in short-term but outlook is brightening.

- Buying the Rupee is one of 2019's "top trades" says Morgan Stanley.

The Rupee will be constrained in its recovery against the Dollar by domestic political uncertainty over coming months, according to some analysts, but others say 2019 could turn out to be a vintage year for the Indian currency.

Indians head to the polls in Rajasthan, Madhya Pradesh, Chhattisgarh, Mizoram and Telangana before year-end, kickstarting what will be a busy six-month period in Indian politics. 

2018's regional votes will have no bearing on the outcome of the general election that is expected to take place before Spring 2019 but markets will view them as a test of support for the government ahead of the ballot.  

Most importantly for the Rupee, a poor showing of support for the governing Bharatiya Janata Party (BJP) could encourage the government to attempt to buy electoral support with promises of higher spending. 

That would be positive for Indian growth in the short-term but negative for the currency if markets see it leading to higher borrowing in 2019 and beyond. 

"Government’s balance sheet/fiscal deficit target will increasingly be questioned by the markets. Our economists expect fiscal deficit to reach 3.7% against the target of 3.3% in FY 2018-19," says Rohit Garg, a strategist at Bank of America Merrill Lynch in an October note to clients. "We believe risks are skewed towards further INR depreciation."

Any expansive budget would come at a time when international investors are demanding increasing rates of interest for lending to developing economies, and when markets are penalising countries that run current account deficits. 

Current account balances measure both the amount of funds flowing into and out of a country as well as the extent to which a nation is reliant upon borrowing from the rest of the world in order to finance themselves. 

Those countries that run large deficits in part because they are borrowing money from international markets will be left exposed to the whims and sentiments of investors that can change at the drop of a hat. 

"Proximity of these polls to next year’s general election also increase its significance, to gauge which way the political winds might blow," says Radhika Rao, an economist at DBS Bank. "Campaign promises have centred around state specific farm loan waivers, welfare handouts, and other one-off promises, which could generate fiscal pressures going forward."

India's currency has been crushed in 2018 by a cocktail of toxic headwinds. U.S. interest rates and bond yields have risen this year, drawing capital out of and away from riskier developing nations, pressuring their currencies.

Furthermore, with the oil price rising by 20% during the 10 months to November, inflation has risen and Indians had already been selling more Rupees on international markets to pay for increasingly costly imports. 

That also threatened to widen the current account deficit, and although the oil market has since gone from boom to bust, there is a risk that government electioneering could encourage fresh concerns about the deficit.  

However, not everybody is concerned solely with the risks likely to be faced by the Rupee over coming months. Some actually see the Indian currency offering investors an attractive opportunity to make a profit in 2019. 

"Despite expecting Emerging Market Asia to underperform the overall EM complex, we highlight select local stories we expect to generate alpha against regional peers," says Hans Redeker, head of FX strategy at Morgan Stanley. "We think that India offers the best growth potential and we expect USD/INR to reach 68 (down ~4% from current levels) by end-2019." 

Redeker says buying the Rupee is one of their top trade ideas for the 2019 year ahead. They anticipate that India will benefit from the ongoing rout in oil markets, which will reduce concerns about the current account deficit.

Morgan Stanley also says India's economy will grow faster than that of any other major country, enabling the Reserve Bank of India to raise interest rates at roughly the same pace as the Federal Reserve, which could neutralise the impact that U.S. interest rate policy has on the Rupee going forward. 

"The RBI is the only Asian central bank our economists expect to hike in tandem with the Fed (50bp in 1H19) and hence our expectation is for Indian real rates to remain wide and INR to outperform," Redeker writes, in a note to clients.

The USD/INR rate was quoted 0.07% higher at 70.70 Monday but has risen by 10.7% in 2018. It had risen 16% going into November.

The Pound-to-Rupee rate was 0.11% higher at 90.66 but has gained 5.2% this year. It had risen almost 10% going into November.

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