Rupee likely to stabilise after a strong rally

Saurabh Jain and Aditya Sharma

Emerging market currencies have had a strong run-up this year, with a broad-based index rising 4 percent year-to-date. The Indian rupee has outperformed, gaining 5 percent to hit a 20-month high recently. While we believe most of the rupee’s strength may be behind us, we are not overly concerned about a sharp reversal.

What gives us such comfort? The first reason is the US dollar’s expected stability following its recent weakness. The second is India’s much-improved fundamentals.

We expect the US dollar to remain stable in the near-to-medium-term. This matters for the rupee (and Emerging Market currencies generally) because the main driver behind this year’s rupee rally is the broad-based weakness in the US dollar as investors scaled back expectations of a fiscal stimulus by US President Donald Trump. There is also the growing perception that the new US administration appears to be mellowing its stance against trade partners and adopting a more pragmatic approach to foreign policy.

Put simply, the risks facing Emerging Markets (EM) around long-standing US trade and defence agreements following Trump’s surprise election victory in November are being pared back. This has resulted in funds flowing back to these markets. Bond and equity market net inflows into EMs now total USD 50 billion year-to-date, surpassing the inflows for all of last year. India has been among the major beneficiaries of the overseas flows.

Going ahead, we expect EM currencies to remain stable as we believe most of the US dollar’s weakness may be over. Within EM currencies, the rupee, along with the currencies of Russia, Brazil and Indonesia are likely to outperform other EM currencies against the USD. These currencies offer the most attractive risk-adjusted-reward due to high interest rates, manageable current account balances and exposure to commodities.

This leads us to the second factor informing our sanguine view on the rupee: India’s strong policy and macroeconomic fundamentals. Favourable regional election results have strengthened the hands of PM Narendra Modi, which should help his administration to push through major economic reforms over the coming years, especially in the land and labour markets, lifting India’s long-term growth prospects. Add to this a relatively hawkish central bank (keeping interest rates elevated and making Indian bond yields attractive) and a strong influx of overseas inflows into Indian equities.

More enduringly, India’s basic external balance (the sum of its current account balance and net foreign direct investment) has improved considerably and remains manageable – this is in contrast to 2013, when the rupee was vulnerable due to a weak external balance profile. India now has sufficient foreign exchange (FX) reserves equal to about 9 months of imports to mitigate any significant outflow pressure. All of these have contributed to the recent gains in the rupee. In March alone, net portfolio inflows amounted to USD 9.1bn, the highest on record.

However, we would be cautious against extrapolating this to expect further rupee strength. There are already concerns about the rupee’s rising valuation, especially when measured against the currencies of India’s major trade partners. Although the Reserve Bank of India (RBI) has stood aside lately, allowing the rupee to appreciate along with other Asian currencies given the overwhelming overseas portfolio inflows, we believe the RBI could return to intervene to limit further, significant rupee gains.

In terms of chart patterns, the rupee broke the psychological level of 64.00 against the US dollar last week. However, its failure to sustain below the 64.00 level suggests it may have found a base at these levels, which could act as a near-term support. On the other direction, the 64.70 near-term resistance level remains intact. Momentum indicators continue to suggest that the US dollar is oversold against the rupee, at least in the short-term.

In the near-term, we expect the rupee and, more broadly, Asia ex-Japan currencies to remain stable amid a moderately positive China growth outlook and expectations of a gradual pace of US rate hikes (we expect two more Fed rate hikes this year). Risks related to European elections also appear to have eased for now.

For sure, some geopolitical risks linger – for instance, the uncertainty around US policy towards North Korea. Other likely sources of risk include renewed concerns about China’s growth outlook or a pick-up in the pace of Fed rate hikes which could lead to renewed US dollar strength. Also, historically the US dollar broadly recovers after a seasonally weak April.

Should broad-based US dollar strength re-emerge, the rupee is likely to be more resilient than other EM currencies, given its solid fundamentals.

Saurabh Jain is Executive Director of head of investment strategy and sales and Aditya Sharma (Director, investment strategy at Standard Chartered's Wealth Management.

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