The INR has seen its worst for this economic cycle. This is a bold statement to make especially in the current environment where tensions in Middle East, Fed withdrawing stimulus, weak domestic economy and potential political chaos looming in the general elections in 2014. However, the level of Rs 68.80 to the US Dollar seen on the 28th of August 2013 is an outlier for the INR and this level is unlikely to be crossed again unless there is a catastrophe in the form of war or the world going back to deep economic gloom.
Why would anyone make such a fool hardy statement when no one really expects one to be positive on India and the Indian economy? After all it is not fashionable to be India positive at present. I am not being patriotic when I say that the worst is over for the INR. One cannot let the love for the country come in the way of cold economic logic. The reasons why the INR has seen its worst are given here.
A) FII selling of INR assets is the primary reason given for the INR fall of over 27% from levels of Rs 54 to the USD seen in April 2013 to Rs 68.80 seen in August 2013. FII’s have sold INR assets but not in any quantum to make the INR fall drastically. FII sales of equity was USD 0.18 billion in the July-September 2013 period while in the April – July 2013 period, FII’s bought USD 2.37 billion of equities. FII’s sold USD 5.77 billion of debt in the April-July 2013 period and USD 1.09 billion of debt in the July-September 2013 period. FII debt sales have declined significantly in the last two months and with the INR at levels of Rs 64 to the USD and ten year bond yields at levels of 8.40%, which is up from 7.10% levels seen in May 2013, FII’s will be buyers of debt rather than sellers of debt. Hence INR fall to Rs 68.80 was more on fears than actual facts and FII’s will in fact turn buyers as risk appetite improves globally.
B) India’s twin deficits, the fiscal and current account deficit are blamed for the INR fall. India’s debt to GDP ratio at 66% is less than that of US that is over 100% and less than that of many other countries including Japan, UK and Italy. US in fact has been running a current account deficit for ages. India’s external debt to GDP ratio at around 22% is well below any levels of worry. Hence, India’s deficits are manageable if there is enough focus on them and the weak INR has given the right wake up call to policy makers to control the deficits. India’s fiscal and current account deficit is expected to be lower in 2013-14 than the levels of 4.9% and 5% of GDP seen in 2012-13.
C) The Syria tensions briefly took brent crude oil prices to levels of USD 117/bbl. Brent was trading at levels of USD 100/bbl in April 2013. The outlook for global oil prices is not at all optimistic given that the US is becoming more and more self sufficient in oil and given that global economic growth is extremely sluggish. US is expected to start exporting oil in 2018 on the back of its shale oil revolution while economic growth from China to Eurozone is trending at multi year lows. Oil prices are likely to come off once tensions ease in the Middle East as basic demand- supply economics take over.
D) The gloom and doom forecast in the Eurozone is now slowing fading away. The Euro is up 8% over the USD since July 2012 while sovereign bond yields of Italy and Spain are down over 200bps. Eurozone economy that was in recession until the first quarter of 2013 saw GDP growth at 0.3% in the second quarter of 2013. Manufacturing data is showing an uptick in the Euro area. ECB has pledged to maintain rates at record low levels until the economy comes out of a slump. The stability in the Eurozone is lowering risk premium across markets. The INR should benefit from the lower global risk aversion.
E) The Fed will start tapering off bond purchases in September as US unemployment rate is down to 7.3% from levels of 9.5% seen a couple of years ago. Fed is aiming at unemployment rate below 7%, not far off from here and it does make practical sense to stop the extraordinary liquidity infusion by the Fed into the economy as seen by the multi fold rise in its balance sheet over the last five years. The Fed is not taking away liquidity but is just stopping additional liquidity infusion. Fed withdrawing stimulus will not affect markets in the long run and INR should benefit from the longer term positive impact of artificial liquidity infusion.
The INR will not strengthen because India has a new RBI governor. Rajan can only take decisions that will be USD inflow positive such as opening a swap window for FCNR (B) deposits for banks or allowing easier access to USD funds for domestic borrowers. Rajan cannot influence flows that are determined by many factors but he can be seen as taking the right decisions at the right time adding an overall friendly atmosphere to the INR.