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August 31 2009
THE Indian rupee was Asia’s worst performing currency in the last four months, depreciating two per cent against the dollar even though emerging markets currencies such as the Brazilian real, the Indonesian rupiah, the Turkish lira and the Korean won surged on an animal spirits rampage by currency gnomes who priced in a cyclical global economic recovery.
Yet green shoots frenzy in the global financial markets, the Congress victory in the May general elections amid the humiliation of the Left Front, a phenomenal 7000 point surge in the Sensex and yet another swoon in the US Dollar Index (with its euro, sterling weighting) was not enough to spark a sustained rally in the Indian rupee. While the INR bounced off a bottom at 52 amid the post Lehman debacle, it has not managed to remotely replicate the strength of the Brazilian real, Indonesian rupiah or the Turkish lira. The Indian rupee is the Cinderella of emerging markets FX in 2009. However, I believe the financial markets have totally misread the bullish case for the INR in the next twelve
months. Why?
One, the Indian trade deficit will shrink by $30 — 40 billion from the 2008 figure of $127 billion. This is due to lower relative commodity prices and contraction of imports, coupled with weak domestic demand as the recession hit the subcontinent’s gigantic economy. However, it is not coincidental that Indian foreign exchange reserves have swelled by $15 billion in 2009, the merchandise trade deficit has compressed and foreign flows, FIIs, into Indian equities resumed with a vengeance. The conclusion is inescapable. The Indian balance of payment has once again swung into surplus, a necessary but not sufficient condition for a rise in the INR.
Two, the Indian rupee was a victim, like all emerging markets, of a tidal wave of risk aversion after the failure of Lehman Brothers last September. The Sensex’s fall from grace was both swift and brutal after it reached its 21000 high in January 2008, when the rupee peaked at 39.30 to the dollar. The INR was a hostage to the FX markets fleeing to Mommy or, more accurately, Uncle Sam, since the dollar is the world’s safe haven in times of financial Armageddon. Yet the Chicago Volatility Index, or VIX, a proxy for Mr Market’s penchant for greed and fear, has now plunged from 80 to 25. Risk appetite and 15000 Sensex both diminish panic tail risk for the Indian rupee.
Three, while the Indian current account shrinks from $30 billion in 2009 to as low as $8 billion next year, India will attract at least $8–10 billion in portfolio flows from the West and FDI from foreign multinationals, particularly if Dr Manmohan Singh’s Congress accelerates the reform agenda in banking and insurance. This means that it is not inconceivable that the Indian balance of surplus rises to $40 billion next year. This is a compelling argument for an appreciation of the Indian rupee.
Four, the Reserve Bank of India, or RBI, has prevented an appreciation of the Indian rupee because exports plunged by one third and it needed to nurture the fragile snapback in GDP growth. This is the reason the INR spot was under pressure since May, foreign exchange reserves accumulated and FX volatility fell. Yet the RBI is now aware that inflation risk in India will only rise. This is the reason the ten year Indian government note yield has surged by 200 basis points. Easy money and a weak rupee are not the policy choice of the RBI at a time when inflation risk is rising and the funding cost of the Congress government’s borrowing binge rises. This means the RBI needs to countenance a higher rupee to dampen inflation risk and arrest the rise in government bond yields. Inflation will be the policy bête noire of the Indian central bank in next year. The Congress government’s bond issuance program is colossal, at $94 billion in fiscal 2010. It is simply not credible that the RBI will allow inflation risk premia to morph into inflation expectations and wreck havoc on the bond market. This is particularly so since private sector credit growth will rise as the consumer revives and banks will dump government securities to meet rising loan demand, meaning interest rates in the rupee money markets could well creep higher. The RBI will have no choice but to allow the Indian rupee to appreciate.
Five, the international financial markets and yours truly are convinced that trillion dollar budget deficits mean Obamanomics is the kiss of death for the dollar. Moreover, I believe the Bank of Japan will print money to avert deflation and the fiscal nightmare in Tokyo will trigger a global run on the Japanese yen. This is a classic international context to buy high carry emerging markets currencies such as the Indian rupee. The Indian rupee’s relative weakness against the dollar contrasts with a backdrop of clearly improving economic, political and financial fundamentals. It is surely significant that the INR did not even drop to 50 when Shanghai shares plunged by a fifth recently and triggered risk aversion across the Asian stock exchanges and Wall Street. The RBI could join the Aussies as one of the first global central banks to tighter monetary policy in the next six months.
The monsoon will clearly hit fiscal 2010 GDP growth, make a mockery of the Panglossian forecasts of Dr Manmohan and Montek Ahluwalia. A poor monsoon will not allow the seven per cent GDP growth forecast by the economic crystal ball gazers in Lutyen’s renamed Viceregal Lodge. Yet the monsoon shock will not derail India’s compelling economic momentum. Infrastructure investments and foreign capital will turbo-charge the Indian GDP in the year ahead. The Indian Rupee is a winner in the next twelve months. My target is 42–44 on the INR. The idea is to accumulate INR warrants on the next market frenzy of risk aversion, particularly when the 6 month NDF forward rate hits 50. A HDFC NRI rupee account might prove to be the best performing bank deposit product in the UAE for the next twelve months because, if I am right, the total return on the account will be 12 per cent for the hapless dollar/dirham saver Barack Obama and Helicopter Ben will inevitably impoverish.
Views expressed by the author are his own and do not reflect the newspaper’s policy.
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