Rupee Forecasts Point Lower as Tax Cuts No Panacea for External Woes

Image © Reserve Bank of India 

- INR sell-off stopped in tracks in September but losses seen by year-end.

- ING says government tax cuts to undermine public finances and the INR.

- Says tax cuts won't solve external ailments, but hurt investor confidence.

- But UBP says INR could rise if Indian stock market celebration goes on. 

The Rupee has held firm against the Dollar and Pound this week because the international environment remains supportive of emerging market currencies but some forecasters are tipping the Indian unit for fresh losses before year-end, in part because of the government's recent shock-and-awe tax cuts. 

Last Friday's tax cuts will reduce the 'effective' corporate tax rate from 34.9% to 25.2% and save Indian corporations around $20 bn every year, or an amount equivalent to 0.7% of economic output. They'll also help to support GDP growth at a time when the economy is under strain from a global slowdown that's effecting external demand, as well as rising resource prices that are stoking inflation and crimping consumer spending, which is why the Rupee has remained on its front foot ever since. 

The cuts, announced by Finance Minister Nirmala Sitharaman, instantly boosted corpore profit margins as well as the value of Indian stocks. They've effectively lit a fire under the stock market, prompting the NIFTY index to rise 5.53% in the week to Wednesday and is now up by a similar amount for 2019 after previously having struggled to keep its head above the waterline. This is a lure for investors, which some say is what's kept the Rupee buoyant this week.

"The INR/USD exchange rate is most sensitive to equity flows so the current equity rally could be the main underpinning factor for a firmer currency," says Anthony Chan, chief Asia strategist at UBP, a Swiss private bank. "However, India’s reduction of current account deficit (to 2.1% of GDP from 5% in 2015) was largely thanks to falling oil prices and recent volatility remains a risk."

Above: USD/INR rate shown at daily intervals.

It could be the stock market rally, the reduced prospect of further interest rate cuts from the Reserve Bank of India (RBI) or a range of other things that have kept the Rupee up this week but regardless, some forecasters doubt that it will remain in such rude health for very long. They say the cost of the tax cuts will weigh heavily on the public purse, which is bad for the currency, and without even addressing the root cause of the economy's problems. 

"There is little that fiscal policy can do to overcome external hurdles to growth, in particular, the recent spike in global oil prices," says Prakash Sakpal at ING. "Whether this helps to kick-start the economy is still to be seen. For now, the negative consequences of derailed fiscal consolidation on India's external creditworthiness keeps up weakening pressure on local financial assets."

India has hit a soft patch but the international root causes of the weakness will not be influenced by the tax cuts, which could mean last Friday's measures fail to revive the economy and that the stock market's newfound won't last for long. Second quarter GDP growth was just 5% annualised, far below the consensus of 5.7% and the economy's weakest pace of expansion for more than six years. It also marked a substantial deterioration from the 5.8% seen in the first quarter.

Above: Rupee (USD/INR blue line, left axis) often moves in opposite direction to oil (green and red).

Without a prompt economic recovery the Indian stock market rally could fizzle out, leaving the Rupee with only an agitated bond market and easing Reserve Bank for company. The RBI has already cut its interest rate by a total of 110 basis points in 2019, providing support to the economy but also reducing the attractiveness of the Rupee in the process and if the economy doesn't recover, the bank could cut rates even further than it otherwise might up ahead.

ING's Sakpal also flags a recent increase in oil prices as reason for doubting the Rupee's ability to continue its September recovery for very long. The country imports more than 80% of the energy it consumes, which is always priced in Dollars and so requires the Rupee to be sold in order to pay for it. Higher prices mean more Rupees being dumped on international markets in exchange for Dollars, and the Brent crude price is up 5% in the last month and 15% for 2019.

"INR did gain some ground amidst the positive swing in sentiment towards the equity market, though we don’t think this will persist given that currency will likely be undermined by weakening public finances, the renewed threat of higher oil prices leading to higher domestic inflation, and the persistently wide current account deficit. We retain our end-2019 USD/INR forecast at 73.50," Sakpal says. ING forecasts a Pound-to-Rupee rate of 86.76 by year-end. 

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

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