Here's why UBS sees no significant upside to the rupee from here

The Indian rupee has witnessed a strong performance in the past two months, with the currency gaining 5 percent. It is now trading at a 15-month high against the US dollar.

A supportive external environment and positive sentiment after the BJP’s victory in Uttar Pradesh elections led to record inflows in portfolios to the tune of USD 8.3 billion in March. The Reserve Bank of India (RBI) was seen intervening to partially prevent the rally.

UBS Securities believes the currency will hover around 65 levels, but sticks to its year-end forecast of 70/USD, implying a weakness.

"The RBI's implicit accommodation of rupee gains suggests a lack of major policy concern at REER (real effective exchange rate) valuations and that there may be downside risks to our year-end USD/INR forecast (70), should FDI and external risk conditions continue to hold up," the research firm wrote in its report.

According to investor education portal Investopedia, real effective exchange rate (REER) is the weighted average of a country's currency relative to an index or basket of other major currencies, adjusted for the effects of inflation. This exchange rate is used to determine an individual country's currency value relative to the other major currencies in the index, such as the US dollar, Japanese yen and the euro.

In the near term, it does not see significant rupee appreciation from current levels. It stated this based on two reasons.

(i) The best of trade balance support may be behind us, with seasonality worsening in April and May.

(ii) Stretched equity market valuations: India is one of the most expensive EM equity markets on a PE basis and this may become a concern, especially if Q4 earnings fail to surprise positively.

Macro variables impact limited

The research firm believes a stronger nominal currency should have a moderating effect on inflation.

“RBI sensitivity analysis implies a 5 percent appreciation in rupee against the dollar might result in inflation moderation of 10-15 bps and economic growth moderation of 10 bps,” its report added.

Nifty earnings to be impacted, but positive for the market

Every 1 percent appreciation in the rupee could lead to a 0.6 percent cut in Nifty earnings, UBS Securities said in its report.

“However, the Nifty's performance, in both absolute terms as well as relative to EM, is stronger in periods of INR appreciation,” it added.

Historically, 5 percent appreciation in rupee in any six-month period has been associated with average Nifty returns of 20 percent. The Nifty is up 6 percent over the past two months. Furthermore, it expects earnings of pharma, metals, mining and IT services to be negatively impacted.

Change in FX management stance?

The central bank’s stance on rupee’s appreciation in February-March has raised questions about change in its forex management stance.

“While we had expected more aggressive intervention, given the elevated level of the REER and weak manufacturing growth, we think it appears too early to conclude there has been a material change in RBI's desire to smooth two-way FX volatility,” analysts at the firm wrote.

Year-end 70/USD forecasts holds

“While there are downside risks to our USD/INR forecasts, we think second half of 2017 may be challenging for EM assets, amid waning base effects for export values, a slowdown in Chinese growth momentum, and potential US tax reform,” it said in its
report.

For INR specifically, despite a strong FDI cushion, the outlook for portfolio flows looks more challenging, while higher oil prices will remain a risk. All this precludes any potential change in US immigration regulations, the report added.