India has a problem of inflation. US, Eurozone and Japan have problems of no inflation. Consumer prices in India are trending at 9.5% levels while consumer prices in US, Eurozone and Japan are trending at 1.2%, 0.7% and 0.7% respectively. The ECB (European Central Bank) surprised markets by reducing the policy rate to all time lows of 0.25% in its policy meet on the 7th of November 2013. Policy rates of the US Federal Reserve (Fed) and the Bank of Japan (BOJ) are also at 0% to 0.25%.
Inflation threshold levels of the Fed, ECB and BOJ is 2% and CPI trending well below 2% levels is forcing the central banks to maintain an ultra loose monetary policy. The Fed and BOJ have asset purchase programs running at USD 85 billion and USD 56 billion a month while the ECB is making liquidity cheap for European Banks. Economic growth in the US printed at 2.8% for the third quarter of 2013 while the Eurozone is just coming out of a recession and Japan is still struggling to show sustainable growth.
India on the other hand is seeing growth at below trend levels while inflation is trending at highly uncomfortable levels. GDP growth is at decade lows for India and CPI has been running at over 9% levels for the last five years. RBI has raised rates by 50bps since September 20th 2013 on inflation worries.
The world is now divided between deflationary worries in the big developed economies and inflationary worries in emerging economies such as India. The currency markets have clearly favoured the deflationary economies given loose central bank liquidity. The Indian Rupee (INR) is down 15% against the USD over the last one year. The INR is trading at levels of Rs 62.58 against the USD as of 8th November 2013. The INR is down 18% against the Euro and up by 5% against the Japanese Yen over the last one year.
The INR has been hit by inflation and current account deficit that touched record highs of 4.8% of GDP in 2012-13. The markets have not favoured the INR despite the interest rate differentials between India, US and Eurozone. Policy rate differentials are at levels of 725bps to 750bps. Going forward markets will find the rate differentials attractive given that the Fed and ECB have pledged to maintain rates at record lows until the time inflation rises and unemployment rate comes off. US unemployment rate is running at 7.2% levels (Fed target is 6.5%) while Eurozone unemployment rate is running at record highs. The earliest indications of rate hikes in these countries are mid 2015.
The INR can benefit from the confidence of policy makers in lowering the CAD by 30% from USD 87 billion seen in 2012-13 to USD 60 billion in 2013-14. The RBI has pledged to bring down long term inflation expectations and if it succeeds through rate hikes, markets will start favouring the INR.
The INR in the near term will move more on market positioning, news of Fed tapering off bond purchases and rate hikes by the RBI. In the medium term, the outlook is far better given improved macro environment expectations and the rate gap with the USD and Euro.