The Indian rupee, which tumbled to a fresh all-time low against the dollar on August 29, is poised to strengthen over the next decade, Capital Economics has said.
“The Indian rupee has continued its long-run trend of depreciation against the US dollar this year, taking it to a record low of 80/$. It may still weaken further in the near term,” Adam Hoyes, Assistant Economist at Capital Economics said in a note on August 31.
“However, there are reasons to think that that the rupee will reverse course within the next decade and appreciate against the dollar on a sustained basis. We think decent productivity growth, an improvement in India’s terms of trade and a narrowing inflation differential will mean the rupee strengthens back to around 70/$ by 2030.”
Expectations that the US Federal Reserve will continue to tighten monetary policy pushed the rupee to a record low, prompting the Reserve Bank of India to step in with dollar sales.
The central bank does not target any particular level for the rupee but seeks to contain volatility through intervention in the spot, forwards and futures markets.
Arvind Panagariya, the former vice chairman of India’s top think-tank Niti Aayog, has called for a depreciation of the rupee to correct the overvaluation compared with peers.
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Slide to continue in the near term
Capital Economics expects the depreciating trend to persist in the near term, as the rally in the US dollar will continue.
“But as we’ve set out before, we think the Reserve Bank has the capacity and inclination to continue stepping in to prevent a rapid depreciation. And once the cyclical factors driving a stronger dollar begin to wane, we think that could be the start of a broader trend of rupee appreciation,” the economic research house said.
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Beyond the next few years, Capital Economics’ forecasts suggest that decent relative productivity growth and an improvement in India’s commodity terms of trade will drive an appreciation in the equilibrium real exchange rate against the US.
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India’s trade-weighted real exchange rate has trended stronger since the 1990s as the country’s productivity growth has outpaced that of its major trading partners.
While the bilateral real exchange rate with the US has held fairly steady over the past decade, it appreciated throughout the 2000s too.
“So for the real exchange rate, we are simply forecasting a return to a trend seen a couple of decades ago,” Hoyes said.
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Moreover, the house expects inflation in India to fall relative to inflation the US, pointing to an appreciation of the rupee against the dollar in nominal terms.
“The rupee has appreciated against the US dollar on a sustained basis before. During the 2000s, the inflation differential between India and the US was low enough to mean that the appreciation in the real exchange rate translated into nominal appreciation too. The rupee strengthened from almost 50/$ in 2002 to below 40/$ by 2007,” the house said.
Besides, a likely secular decline in prices of energy commodities, such as oil and coal, in the coming decades will lead to a significant improvement in India’s terms of trade and make up for a smaller productivity differential.
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