The Mega Rupee Strength!

During the last 15 months, Euro fell by nearly 25%, Brazilian Real by 30%, Russian Ruble by 50% and Canadian dollar by 18% all against the USD. The INR is down only by 2%!

My previous article on Indian rupee was written during August 2013 titled “The Mega Rupee Slide” when Indian Rupee (INR) was sliding down as if there was no tomorrow. The question back then was, how low the INR will go and how can this be stopped.

Within two years, that question is now flipped over its face. This time around, the motivation to look at INR was for the opposite reason. When almost all global currencies are sliding down against US Dollar (as if there is no tomorrow!), INR is holding up quite well.

This indeed is a very strange situation for an emerging market like India. Can this hold up or Is this just a calm before the storm? This question is important for CFO’s, Foreign Investors, Importers, Exporters and finally NRI’s.

Depreciation Relative to USD	2014	2015-YTD (18th Mar)
Brazilian Real	-11.1%	-18.4%
Euro	-12.0%	-12.4%
Canadian Dollar	-8.6%	-9.3%
Australian Dollar	-8.4%	-7.1%
South African Rand	-9.7%	-6.6%
Indonesian Rupiah	-1.8%	-6.0%
Malaysian Ringgit	-6.2%	-5.7%
Russian Ruble	-43.3%	-5.4%
Singapore Dollar	-4.7%	-4.7%
Mexican Peso	-11.6%	-4.2%
Korean Won	-4.0%	-3.2%
Japanese Yen	-12.0%	-1.3%
Chinese Yuan	-2.4%	-0.5%
Hong Kong Dollar	0.0%	-0.1%
Thai Baht	-0.7%	0.0%
Taiwanese Dollar	-5.7%	0.2%
Indian Rupee	-2.0%	0.6%

But before we answer that question, let us understand what has caused this rapid USD strength against Euro and other currencies. Euro has plunged by nearly 25% since 2014 beginning from 1.4 to nearly 1. The simple explanation to this unprecedented plunge of Euro is the divergent monetary policy of US and Eurozone. US is now in a tightening mode (means increasing the rates) while Eurozone is now in a loosening mode (means reducing the rates). So, when US rates go up and Eurozone rates fall, the spread widens and therefore causes more capital to flow back to US in search of more yields which then results in currency appreciation.

Why is INR so strong?

There are many reasons, but three stand out:

      1.       “Strong”  and improving Economy

      2.       “Prudent” RBI &

      3.       “Rocking” Capital markets

 “Strong” Economy:

“India’s near-term growth outlook has improved and the balance of risks is now more favorable, helped by increased political certainty, several policy actions, improved business confidence, lower commodity import prices, and reduced external vulnerabilities” IMF, March 2015. That is a neat summary of where India is in terms of its economy.

Economic Indicator	2014/15	Current Assessment	Future Assessment
Real GDP growth (%)	5.6	Rebounding	Positive
Inflation (%)-CPI	6.7%	Reducing	Stable
Current Account Deficit (% to GDP)	-1.8%	Narrowing	Stable
Fiscal Deficit (% to GDP)	-4.4%	Declining	Declining
Forex Reserves ($b)	340	Strong	Strong
Public Debt (% to GDP)	64.3	Moderate	Moderate
Data Source: IMF

India is among very few countries in the world that is expected to clock decent real GDP growth for 2015 and beyond. IMF projects a growth of 5.6% for the current fiscal and 6.3% for the next fiscal, a healthy number indeed. The rebound in growth is happening on the back of improved political climate, lower oil prices, increasing confidence among business and investors, and reduced external vulnerabilities as IMF summarized. However, if you look at the projections for say 2019/20, it still remains only at 6.7%, not the 10% that the media loves to tout all the time. If India’s medium-term prospects were to be improved, we should focus removing supply-side bottlenecks.

The reduction in consumer inflation is commendable and timely. The reducing inflation is credited mainly to lower oil prices though RBI’s relentless pursuit to contain inflation is finally paying off through its monetary policy actions. The government’s effort to contain food inflation is also a key contributor here.

India also suffers from the twin deficit problem i.e., fiscal deficit and Current Account Deficit (or what is popularly called CAD). CAD is now at -1.8% of GDP, far lower than -4.7% witnessed during 2012/13. The improving situation is mainly because our import bills are coming down while exports have picked up. Imports have come down mainly due to lower oil prices as well as fall in gold imports (thanks to higher import duties and administrative measures). India has received an unexpected gift in the form of lower oil prices translating into lower import bill. Oil comprised nearly 40% of our import bill before the oil price collapse and hence it is a great relief to be experiencing a lower oil price. But, we do not know how long this gift will last. Future assessment of CAD is also very stable at -2.5%.

Presently India’s fiscal deficit stands at -4.4% showing a declining trend relative to history. As per IMF, it is further poised to reduce though the task is one of great challenge. The fiscal deficit can be reduced only if we increase the revenues or decrease expenditure or do both. Reducing expenditure will involve overhauling the subsidy regime mainly to stop leakages in food subsidies. Improving revenues will involve tax administration reforms.

Our forex reserves at $340 billion is increasing and provides decent cover for our imports (7 months). The growth in our forex reserves is happening on the back of strong FII inflows and narrowing CAD. This is further augmented by NRI deposits and overseas borrowing by corporates through ECB’s. Indian corporates are highly leveraged and normally unhedge their forex exposure. If you notice carefully, all these sources are short-term and volatile. India should look to building its forex reserves through long-term stable forms like FDI. A good comparison here would be China whose forex reserves are close to $4 trillion dollars mainly built on the back of export surpluses. Due to this, China in fact enjoys a current account surplus.

India’s public debt as a % of GDP is about 65% and is considered moderate compared to other countries. Moreover, our total debt is about 135% of GDP (Government: 66%, Corporates: 45%, Households: 9% & Financial Institutions: 15%). Contrast this with say China at 282% of GDP (Government: 55%, Corporates: 125%, Households: 38%, & Financial Institutions: 65%). China’s total debt has grown four times in the six years since global financial crisis and its debt-to-GDP ratio has doubled between 2007 and 2014 according to an analysis done by C.P. Chandrasekhar and Jayat Ghosh and as published recently in Business line. Even though the aggregate debt level for China is high, its current account surplus can weather any storm, while India does not have that luxury. That said, Indian public debt scenario is highly sustainable with favorable maturity structure, currency composition as well as domestic investor base according to IMF.

 “Prudent” RBI

Raghuram Rajan is arguably one of the deft Central Bank governors in the world today. When the new Modi government took charge, one of the best decisions they made is to retain him as the governor of RBI. RBI’s main mandate is to contain India’s uncontainable inflation and he managed to do that exactly, though with a little bit of help from oil price. However, he did not wait for the “lower inflation” thesis to play out fully before decreasing India’s interest rates. He surprised the market with a 25 basis point cut on March 4. Remember, our interest rates are high in response to high inflation and this has been touted as one reason for economic growth not picking up. In other words, many were blaming Raghuram Rajan as obstructing and delaying India’s economic growth. He surprised many when he made a sudden announcement to increase the rates. It shows his conviction that the reduction in India’s inflation is here to stay.

 “Rocking” Capital Markets

A strong capital market attracts foreign investments which contributes to rupee strength. Indian stock market is one of the best performing stock markets in the world. It netted a return of 30% for 2014 and is up by 3% so far in 2015. Strong capital inflows, optimism about reforms by the new Modi government, proactive RBI and huge expectations of infrastructure spending augurs this strong performance of the stock market. Foreign investors are also eagerly buying Indian debt. As markets perform well, the foreign inflows will tend to appreciate the currency and this can be one reason as well. However, Indian markets are not cheap as measured by price to earnings ratio at 17.8 for MSCI India based on forward earnings, which is nearly 25% higher than the long-term average. Valuation can get affordable only if earnings catches up.

What can spoil the party

Two things can spoil the party in my assessment:

      1.       Global market volatility &

      2.       Anemic credit growth magnifying NPA problem

Global Market Volatility:

Everyone from Raghuram Rajan to Arun Jaitley (India’s Finance Minister) is bracing for the “winter” in global financial markets when US Fed will start raising interest rates after a prolonged period of low interest rates. The question is no longer “if” but when. And the rate rise can start either as early as June or at the worst by the end of the year. When US did a “taper tantrum” last time around in 2013, every emerging market felt the heat including India. This time around this event of rate rise is even more powerful than “taper tantrum”. Given the negative yields in Eurozone, a rate rise in US is definite to pull back capital to US. This means hot money will leave the shores of other markets (especially emerging markets) in search of more yields in US. Indian markets are predominantly served by hot money and hence it may have a chilling effect for sure. Let us hope that the policy normalization is not disorderly and inflicts minimum pain for India.

Anemic Credit Growth

The other major concern is the huge swathe of non-performing loans building up in public sector banks coupled with weak credit growth. Accordingly to IMF, the profitability of public sector banks remains weak, due to lower operating efficiency. Large exposure of these banks to infrastructure has turned their asset quality very poor. Due to this, the capital requirements for public sector banks has increased. Basel 3 adoption also increases this pressure. Weak credit growth (at 10%) may not help matters.

Concluding Thoughts

INR is currently trading at Rs.62/USD. Leading investment banks mostly predict Rupee to continue to be strong in 2015 as we can see in the table. While Nomura call is aggressive at Rs.57.5/$, Goldman Sachs predicts INR to reach Rs.63, not too different from the current levels.

	INR Forecast -2015-per USD
ZyFin Research	58
Bloomberg survey	61
Nomura	57.50
Deutsche Bank	64
BoA Merril Lynch	60
Goldman Sachs	63
Reuters poll	62.50

The rapid rise of US dollar and the concurrent rapid fall of Euro surprised many analysts. However, what is even more surprising is the strength of Indian Rupee. This may well reflect the solid Indian economic story. However, currency is a volatile game and few can predict its movement accurately. Among the key risks discussed, IMF flags a surge in financial market volatility as the highest risk for India in 2015 apart from protracted period of slower growth in advanced economies. Hence, it is quite clear that the storm is coming. The question is how well we can cope with it. When that storm arrives, the Indian Rupee should give up and move down to say 65 or even 70 levels if the Fed monetary policy unwinding is orderly. The role of RBI is to make sure that this downward movement of INR is orderly and does not create panic among market participant. Given Raghuram Rajan’s track record so far, it is quite to be expected that he will manage the process well.