Rupee "Undervalued" say Analysts but Recovery from Record Lows will Take Time

-INR is "undervalued" at current record low levels say UBS. 

-But a recovery will take time as multiple headwinds still remain. 

-Risk is to the upside however, given strong growth and RBI support.

© Ash T Productions, Adobe Stock

The Rupee is undervalued at its current depressed levels, according to analysts at Swiss banking giant UBS, but it will take time for the Indian currency to recover from the record lows it has plumbed repeatedly during recent weeks.

India's Rupee has fallen 7.8% against the Dollar and 5.7% against the Pound during 2018, with much of these losses coming in the 11 weeks since the middle of April, as investors fled from emerging market currencies in their droves.

A resurgent greenback, which has converted a 4% 2018 loss into a 2.29% gain during the same time period, and rising US bond yields are at the heart of these moves. So too are US tax reforms and a 16.7% increase in oil prices, which have driven domestic inflation higher, thereby hampering the currency and threatening economic growth.

"Looking at the INR on a Real Effective Exchange Rate (REER) basis and using the Harrod-Balassa -Samuelson (HBS) theorem to adjust for the productivity differential with trading partners, our model indicates the INR has overshot its equilibrium value and is undervalued at its current level," says Tanvee Gupta Jain, an economist at UBS. "However, fair value models should be taken with a grain of salt."

The slide has seen the Rupee reach record lows this year and, although it now sits below what UBS analysts say is "fair value" for the currency, there have been longer periods in the past during which the Rupee has carried an even steeper discount to its "fair value".

Above: USD/INR rate shown at daily intervals.

The Pound-to-Rupee rate was quoted 0.09% higher at 91.25 Wednesday while the USD/INR rate was 0.10% higher at 68.81. The USD/INR rate reached a joint all-time high of 69.16 back in June, which is an all-time low for the Rupee. 

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

The UBS team explain in their latest note why it may be some time before the currency is able to climb out of the quagmire this time around too. Economic forecasts and commentary from elsewhere also support this view.

"In 2013, the rupee weakened c15% past its fair value. In the near term (the next 2-4 months), we believe depreciation bias in the INR is likely to remain. Indeed, we expect the INR to remain at 68 -72 against the USD, largely led by three factors," Jaine writes, in a recent briefing. "Towards year-end, a weaker USD could come to the rescue."

A Series of Headwinds 

India's balance of payment deficit is expected to rise this year, thanks largely to changes in the import and export mix as well as due to offshore factors like the US tax reforms.

India's fast growing economy is fuelling increased imports of international goods which, at the most basic level, is problematic because it means more Rupees being dumped on the market in order for companies to buy the other currencies needed to pay for imports. This bad for the trade and current account balances, which reflect real world supply and demand for a currency.

The US tax reforms have been problematic too in that they have so-far hoovered US Dollars from the international financial system, making the greenback more expensive to borrow and buy on international markets. This is a problem because emerging market debts are often denominated in US Dollars, which means they are more expensive to service during times of rising US interest rates, US Dollar strength or currency weakness in the emerging world.

Rising rates of interest in the US, an American economy that is in rude health and concerns about future financial pressures in India have seen international investors dump Indian government bonds by the bucket load this year, which has fulled an increasing supply of Rupees for sale in the foreign exchange market and also helped to push the currency toward its recent record low.

India's election, due at an unscheduled time in the first half of 2019, is another reason why the Rupee may remain under pressure in the short term. Uncertainty about the future state of the public purse and likely evolution of domestic policy is expected to see international investors remain cautious ahead of the vote.

Rupee Forecasts

"Towards year-end, a weaker USD could come to the rescue. As such, we retain our forecast of INR/USD at 66 by end Full-year 2019 and 66.5 by end-FY20," says Jain.

Fortunately for the Rupee, few analysts appear to think the US Dollar can continue its recent march higher. In fact, many say it will soon face renewed losses as economic growth pick back up in other parts of the world, following a slowdown earlier in 2018.

UBS' Jain also forecasts renewed losses for the greenback, eyeing a recovery in the Euro-to-Dollar rate, from around 1.18 this week, to 1.30 before year-end. This broad easing of the Dollar should also mean respite for the Rupee, which is expected to rise back toward its current "fair value" over the course of 2019.

Risks to Jain's forecasts for the Rupee may well be to the upside over the next six months, particularly if what other economists are saying about the economy and central bank prove to be correct.

"India’s official GDP data show that growth accelerated to a six-quarter high of 7.7% y/y in Q1. We think the economy will continue to grow impressively over the coming quarters," says Shilan Shah, an economist at Capital Economics. "Private consumption will remain the key driver."

Sha and the Capital Economics team were one of only 14 forecasters, out of a total of 40, to correctly predict the Reserve Bank of India would raise interest rates in June. The RBI's hike was the first time since 2014 but Capital Economics are forecasting two more interest rate rises, which would take the cash rate up to 6.5%, over the next "six months or so".

Interest rates, and speculation about them, are the raison d'être for most moves in currency markets. Changes in interest rates, or hints of them being in the cards, are only made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

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