The renewed weakening of the Indian rupee to a fresh all-time low of 86 against the US dollar comes in the backdrop of a resurgent dollar index, which has risen by 8 percent over the past three months (from the end of September 2024). This development is significant as it impacts India's financial conditions, particularly in equities and bonds, which are now part of global indices.
A modest 8.3 percent YoY return (from January 5, 2024 to January 5, 2025) from the benchmark India equity indices, Nifty, and Sensex, is significantly lower than 26 percent from US S&P 500. And with a 3 percent YOY INR/USD depreciation the underperformance is starker. Thus, with growth underperforming, the prospect of a sharper depreciation is palpable.
Why is the dollar strengthening?
The US economy has emerged stronger than expected which has forced the US Federal Reserve to scale back two out the guided four rate cuts in 2025. With Trump 2.0 the impact of his expansionary corporate tax cuts and tariff hikes implies the likelihood of elevated inflation, leading to the US Federal Reserve staying hawkish.
Consequently, the widening growth divergences with Eurozone that continues to face persistent economic challenges puts dollar advance economies (AE) index on a stronger footing.
China has been running down its dollar reserves while also adopting greater currency flexibility to counter slowdown. This will have a bearing on the Dollar Emerging Markets (EM) index.
Trump 2.0 mercantilism is also geared towards bringing down the US public debt/GDP ratio from its peak of 123 percent, thereby making it imperative for the US to keep USD supported.
And the added sliver for the dollar is the surging geopolitical risks inducing increased global policy uncertainty.
Rupee’s de-facto peg untenable
INR/USD has demonstrated remarkable currency inflexibility over the past two years enabled by aggressive usage of forex reserve management by the Reserve Bank of India (RBI), on both sides. Our currency inflexibility measure shows that while at 0.38, CNY is increasingly getting flexible, INR at 1 is mimicking a peg [0 represents a fully flexible currency and 1 represents currency peg].
Since October 2024, the RBI’s foreign currency assets (FCA) declined by $47 billion leading to Rs 4 trillion of domestic liquidity drain and a deficit liquidity situation, notwithstanding the 50 basis points CRR cut and purchase of Gsec by the RBI.
But this position is becoming untenable as the rapid strengthening of dollar is accentuating the misalignment. An aggressive rundown of forex reserves may reduce the RBI’s ability to control markets, as rising merchant transactions may bet in favour of a weaker rupee.
Domestic factors that could weaken the rupee (INR/USD)
Since 2008, INR/USD has depreciated more (90 percent) than the other currencies (38 percent EM dollar index, and 21 percent AE dollar indices) because of the narrowing growth differential versus global. Thus, any downside surprises in growth performance can make the rupee vulnerable.
In recent quarters, Indian companies have seen profit contractions from the episodic post pandemic upsurge.
The pervasive demand weakness and margin pressure forebode further moderation even for the coming years; Consensus Nifty EPS growth for FY25-FY27 is placed at 11 percent CAGR. These compared weaker than the projected earnings for US S&P500; 16 percent for 2025E and trailing 4 quarter at 8 percent. Relatively lower PEG for the US markets may continue to impact FII flows.
Fair value for INR/USD at 90-92
Our global models with assumptions of a) a strong US nominal GDP growth at 4.6 percent in 2025, b) higher rates for longer translating into 10-year US Treasury yield at 4.0 percent versus current 4.6 percent, and c) 2-months Treasury yield less 5-year breakeven inflation at 1.9 percent could imply strengthening USD against both EM dollar index and INR/USD. Consequently, the EM currency index could depreciate by 5 percent and INR by 7-10 percent.
From the domestic framework of a weak growth phase, the trend depreciation is estimated at 4 percent with a peak depreciation level of 9 percent. At 3 percent YoY, it is currently in the lower band, implying a latent steep depreciation. Additionally, the negative India-US real policy rate spread (-1.7, November 2024) and overvaluation of the broad real effective exchange rate (REER) will weigh on the exchange rate.
Considering all factors our estimates suggest that INR/USD can depreciate by 7-10 percent from the recent pegged levels of 84 to 90-92 in the coming 6-10 months.
Policy imperative
RBI’s currency inflexibility, in contrast to the flexibility of the CNY and the strengthening of the USD, makes it imperative for the RBI to allow for a higher currency depreciation and ease its interventions. Improved growth impetus by easing the debilitating impact of currency inflexibility can reduce the urgency for immediate repo rate cut.
The drop in currency volatility contributed to outsized dividend payouts by RBI to the Government of India (Rs 2.11 lakh crore in FY24); it may reduce it going forward.
Sectoral impact: Cyclicals more susceptible to INR weakening
High beta and rate sensitive sectors such as banking and metals would be susceptible to sharper INR weakening. However, a strong US profit cycle along with a weak INR/USD may aid export-oriented sectors, specially IT and pharma. Softening commodity prices in a strong dollar scenario can provide an impetus for metals consuming sectors such as automobiles.
Postscript
Currency movements are fraught with considerable uncertainties relating to global growth, intensifying protectionism, geopolitics and differential monetary policy responses.
Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
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