Think Tank

Currency and Interest Rate Outlook

Haresh Desai,Founder-Partner and Director of Rajwade Treasury Consultants and AV Rajwade & Co

John Maynard Keynes famously said about the currency markets that, ‘The inevitable never happens. It’s the unexpected always.’ This has certainly been true of the rupee exchange rate in recent weeks. After a roller coaster ride in mid-2018, when it quickly moved from 65/USD down to 74.5 and then back up to 69, the Indian currency appeared to have stabilised. However, two unrelated events – an escalation of the US-China economic dispute and renewed political tensions at home, mainly because of the government’s decision to abrogate Article 370 of the Constitution – have brought renewed volatility and a sharp drop in the rupee. This volatility is likely to sustain in the short term but over a longer horizon, the rupee is likely to regain lost ground.

Over a 2-3-month period, the rupee may slide further, possibly even dropping to 74-75/USD before the RBI steps in and starts selling dollars aggressively. In October 2018, when the Rupee touched 74.5/USD, the central bank appears to have sold off USD 5 billion of reserves over a period of a few weeks. Broadly, four factors will be at play during this time:

Affordable housing has got a big push but states will need to be roped in more closely

Mass housing
In the last few years, the Centre has made a big push on affordable housing, particularly through its PMAY scheme. Many of these developments, however, are in somewhat remote locations, and some lack basic amenities such as reliable water or electricity supplies. There also appears to be a growing disconnect between the Centre’s own efforts and those of the states, which run their own mass-housing programmes. Going forward, the entire project may need to take on a more federal structure for it to succeed.

A major attack could cause the rupee to plunge

Renewed tensions with Pakistan over Kashmir:
Given what an emotive issue Kashmir is for Pakistan and judging by its strong reaction thus far, either the Army or the government will need to do something to demonstrate its ‘resolve’. This could take the form of a military adventure or a terror attack, most likely – since winter is a difficult time to stage an attack – sometime in the coming weeks. Such an event would bring markets under pressure causing the currency to fall by 1-2 rupees, and more if the conflict intensifies.

The ‘war’ between America and China is intensifying and spilling into new areas

Escalating US-China tensions:
China’s move to push its exchange rate below 7/USD was clearly a red rag to Donald Trump. The American President, in turn, has been widening the trade conflict in the belief that tariffs will not only reduce the trade deficit but also slow down Chinese growth. Regardless of how events play out in the next 12-18 months, or who wins the 2020 Presidential election, this second factor will ensure a prolonged economic ‘war’ between the two. At current rates of growth, China would displace America as the world’s biggest economy sometime in the next decade. No American leader will want to concede the ‘top spot’ (which the US has held since 1905) to another country, so he/she will be tempted to undercut China, regardless of how much this hurts the US itself.

No one can tell what direction Brexit will take

Uncertainties about Brexit:
Euro/USD and GBP/USD exchange rates are largely a multiplicate of these and the rupee’s rates against the dollar. However, what course Brexit takes over the next few months will have knock-on effects on the USD-INR rate. Brexit, particularly a hard Brexit, will hit both the UK and Europe. It could also cause the pound to drop to 1.1 levels, and the euro to 1.03-1.04. Aside from driving up uncertainty in the forex markets, the euro’s fall would push China to devalue, taking the rupee down with it. On the other hand, if Brexit is ‘kicked down the road’ to next year or even reversed via a second referendum, both the pound and the euro would strengthen, to 1.25-1.3 and 1.2-1.22, respectively.

An upsurge in the Middle East would cause oil prices to spike, dragging the rupee down

A spike in hostilities in the Middle East would drive up oil prices, which have so far been tame. Despite the ongoing stand-off with Iran, prices of Brent – which makes up 90% of India’s oil imports – have stayed in the range of USD 57-58/barrel. A serious escalation from this stage could take prices up to 80/USD, and gold up by 10-20%. Given that each USD 10 increase in oil prices raises India’s import bill by USD 1 billion/month, this would put intense downward pressure on the rupee.

Three factors suggest that the rupee should return to 69-70 levels sometime between December 2019 and March 2020:

The trade and current account deficits are likely do narrow over FY20

A fall in dollar demand:
Indian exports are strongly correlated with GDP growth in the US and Europe and as these regions slow, export growth will decelerate or even turn negative. The flip side is that imports will fall even faster, given soft global prices of commodities like oil, copper, steel, other metals and chemicals. Over 2019-20, the trade and current account deficits could fall by USD 10-12 billion, reducing India’s net dollar demand.

A sovereign bond issue may not happen but Indian PSUs are expected to tap into ECBs of USD 8-10 billion

An increase in the supply of dollars:
The Finance Minister’s recent announcement that India is considering a sovereign-bond issue received much flack, including from two former RBI Governors. On balance, their criticism – that it leaves India vulnerable to global bond speculators – is only justified if such issuances reach a critical mass (~USD 100-150 billion). It is unclear whether India will actually go down the sovereign-bond route but it is likely to tap global markets for borrowings of about USD 8-10 billion this year to fund infrastructure. Possibly, this could come in the form of external commercial borrowings by PSUs. Should this happen, it will greatly increase the supply of dollars, pushing the rupee up.

The RBI will probably step in to restore the rupee to 69-70 levels if it drifts too far

Open-market operations by the RBI:
There is much debate about whether the rupee is over- or undervalued, and by how much. Depending on which of the RBI’s 4 REER (real effective exchange rate) indices one uses, it is possible to justify any number between 65/USD and 82/USD. The 36-country WPI index puts it at 65-66, while the 6-country WPI index places it at ~70. Using the CPI, the ‘true’ exchange rate should be either ~75 (36 country) or 81-82 (6 country). Judging by its past market interventions, the RBI appears to favour the 6-country WPI index, stepping in whenever the currency drifts up toward 65 or down to 75. As recently as July, it stopped the rupee from appreciating past 68.5. This suggests that it will step in if, as seems likely, the rupee continues to move down.

The upshot: CFOs should be hedging all exposures

All said, companies with a foreign-exchange exposure should today be hedging, mainly through the use of option contracts rather than forward contracts. Euro- and GBP-denominated payables and receivables, in particular, could move up or down in value by as much as 10% in the short term. On the other hand, with both US and Indian interest rates likely to come down at roughly the same rate, India-US interest-rate differentials will not change much, and nor will forward premiums. Businesses with exposure to emerging markets in Latin America and Africa should also be hedging their full exposure because these currencies tend to move very sharply, to the extent that they can impact business continuity. The broad aim should be to not sacrifice the ‘good’ that can be secured with options by waiting for an imaginary ‘better’ in the spot markets.

The rupee may depreciate at a slowing rate in the coming years…

but low inflation adds to the urgency of bringing down real interest rates

USD 5 trillion by 2024 may be ambitious

The view to 2024
In the long term, exchange rates are determined mainly by inflation differentials between countries. For over a decade, high domestic inflation has caused the rupee to lose roughly 3% a year. However, one of the big achievements of the NDA has been to markedly reduce CPI inflation. If this is sustained – which is likely, given the government’s commitment to fiscal consolidation – the rupee’s depreciation should slow. Lower inflation will also add to the urgency of bringing down real interest rates. One of the main pain points for corporate borrowers, especially SMEs, is the huge gap between market interest rates (9-10%) and inflation (3-4%). Unless real rates come down, the dream of achieving a USD 5 trillion economy by 2024 is unrealistic. Even if the rupee stabilises, real GDP would have to grow at 9-9.5% a year to get to USD 5 trillion. It will probably be 7-8 years before this happens, which would still make it a remarkable achievement. Hand-in-hand, per capita incomes will jump – from ~USD 2,000 today to USD 3,000-3,500 – in the next few years, given that the population is starting to stabilise. This will also fuel a huge consumption boom.