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Rupee on the ropes

The Indian rupee has fallen sharply in recent sessions, despite the Reserve Bank of India’s (RBI’s) efforts to stabilise the currency through monetary tightening, says Brian Jackson, Global FX Strategist at Coutts…

We believe tighter policy will further impede growth, while the rupee is vulnerable to further weakness, and maintain a negative short-term view on Indian equities.

The strong dollar has heightened volatility in emerging markets and the Indian rupee (INR) is suffering more than most. The rupee has weakened almost 15% since late April, and may weaken further. The RBI has sought to stabilise the currency since May by tightening liquidity, though this may ultimately curb domestic growth and demand for rupee-denominated assets, in particular equities.

It’s hard to see the RBI being able to control the rupee’s fall without further impeding growth, either by pushing up bond yields or making it more difficult to access bank financing. India’s structural challenges of a large current account deficit (trade in goods and services) and persistent inflation still have to be resolved.

Weak growth is itself a reason to minimise rupee exposure amid a general strong-dollar trend. This is particularly so with US yields rising in advance of an expected end to US quantitative easing (bond purchases), while rupee government bonds are yielding less than zero after inflation.

RBI efforts to prop up the rupee

In July, the RBI announced measures to tighten credit and raise short-term rates, while continuing its clampdown on gold imports (a large driver of the current account deficit). The RBI announced further measures in early August, including restrictions on the money Indian companies and individuals can invest or remit overseas. The last measure suggests officials are increasingly concerned about capital outflows, which could raise the risk of more draconian capital controls.

Rupee could fall further

Rupee sentiment is very fragile. We adjusted our forecasts earlier this month to reflect the weaker growth outlook. The dollar is already trading above our end-September forecast of 62.0 rupees, with risks skewed to the upside for our year-end forecast of 64.0.

Recent policy measures could also undermine investor confidence in the rupee. Measures aimed at curbing capital outflows have raised foreign investor concerns that capital controls could be introduced, despite government assurances to the contrary. Recent downswings appear to have been at least partly driven by efforts to repatriate funds out of India before any such move. With India’s foreign reserves at a three-year low, markets may test officials’ ability to defend the rupee through intervention in the currency markets.

Prospects for a turnaround

A sustainable recovery in the rupee will require an improvement in India’s economic outlook. Policymakers and investors will be watching to see whether recent currency weakness has increased inflationary pressures or led to any improvement in the current account deficit.

Growth implications

Although the RBI has stopped short of raising interest rates, the tightening measures have diminished hopes of a near-term rate cut.

The RBI will have to focus on both currency and inflation risks. Near-term inflationary pressures are also tying the RBI’s hands. Wholesale prices surprisingly rose 5.8% in July versus 4.9% in June. Consumer prices in cities are rising at over 10%. This suggests that liquidity tightening is unlikely to be lifted anytime soon, and economic recovery will be further delayed. Growth is likely to remain below 5% in 2013 and new RBI governor Raghuram Rajan is unlikely to be able to pursue growth-friendly measures until the currency stabilises.

Challenges for Indian assets

We remain tactically underweight on Indian equities given the risk of additional losses if growth is impeded further. Bank shares in particular look likely to remain volatile in the tight liquidity environment. With growth uncertain and corporate earnings uninspiring, we don’t see any near-term scope for earnings upgrades.

We also remain cautious on Indian bonds, although selective opportunities exist in shorter-dated dollar-denominated corporate bonds.

The RBI’s measures to tighten liquidity have pushed bonds lower across maturities, with the greatest sell-off in short and medium-term bonds. The Indian 10-year government bond now yields 9.0% (versus 8.1% at the start of the month). The yield on 12 month T-bill is now 10.1%. Yields (which move inversely to prices) on Indian government bonds are likely to remain high and volatile given the delays to monetary easing.

Catalysts for a sustainable turnaround

The RBI’s measures will need to have a sizeable impact on the current account deficit and rupee before growth can recover meaningfully. The government aims to reduce the current account deficit to 3.8% (from 4.8% in the previous fiscal year) but inflation remains persistently high.

If gold imports are successfully controlled and the currency stabilises, the government and RBI can shift their focus back towards boosting growth. The currency and equity market could then start to look attractive again. However, we think a shift of focus back to growth is unlikely in the near term and volatility is set to continue until year-end.

Elections in May 2014

With the Indian general election coming up next year, announcements over reforms will likely be quiet. After the slew of reforms announced since last September, which boosted market sentiment at the time, further significant measures aimed at containing the fiscal deficits or increasing investment may be delayed until after the polls.

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