The Reserve Bank of India switch to a neutral stance will underpin the rupee in the short term. Policy uncertainty will tend to deter capital inflows and the global environment is likely to be significantly less supportive as the Federal Reserve tightens policy further. As dollar liquidity declines, emerging-market currencies will tend to weaken and the rupee is likely to lose ground, especially if global equity markets are subjected to significant selling. Overall, although volatility is likely to increase, gradual depreciation is the most likely outcome with further USD/INR support below 67.00.
The rupee has strengthened during 2017, supported by a slightly weaker US dollar and buoyant equity markets, but USD/INR found support below 67.00.
Headline Indian inflation declined to an annual rate of 3.17% for January from 3.41% the previous month and contrary to expectations of a smaller decline to 3.22%. There was further downward pressure on food prices with a slowdown in the annual rate to 0.53% from 1.37% as the clampdown on cash helped curb price increases.
Underlying inflation rose to 5.1% for the month after holding just below 5.0% for the previous few months. The Reserve Bank of India (RBI) remains concerned surrounding an increase in underlying inflation, especially as there has been upward pressure on energy prices. The central bank has an inflation target of 5% for the year to March and a medium-term target of 4% with a 2% margin on either side.
The RBI held interest rates unchanged at 6.25% following February’s central bank meeting, contrary to expectations that there would be a small cut in rates. The central bank also switched to a neutral policy bias following the decision from an accommodative stance previously. There are expectations that there could be rate hikes later in 2017 with the bank determined to control inflation.
There are still important uncertainties surrounding the medium-term impact of the November 2016 RBI decision to outlaw old high-value rupee notes which triggered a very sharp decline in currency in circulation. The most likely outcome is a sharp dip in activity during the first half of 2017 before a recovery as re-monetisation takes effect, but there is a significant risk that the initial downturn will be steeper than expected.
US Federal Reserve policies will remain a crucial focus over the next few months and will have an important impact on rupee trends.
The Fed increased interest rates to 0.75% following the December meeting and current expectations are that there will be at least two further rate increases during 2017. Relatively hawkish rhetoric from Fed Chair Yellen increased speculation that there could be three rate increases during the course of this year.
A more aggressive US stance in tightening policy would have an important impact in undermining rupee support with a narrowing of yield differentials.
Wider trends in emerging markets will also be a very important underlying market focus over the next few months, especially if there is a more aggressive policy tightening by the Federal Reserve. Higher US interest rates will tend to sap global dollar liquidity and there have been persistent concerns surrounding a potential global US currency shortage.
If there is a significant further deterioration in dollar liquidity, emerging-market currencies will tend to come under pressure and the rupee would be likely to weaken.
The impact will be potentially much more serious if there is a wider deterioration in risk appetite and downward pressure on equity prices. In this environment, there would be a much higher risk of investment funds pulling funds out of emerging markets which would have an important negative rupee impact.
International investors remain uneasy surrounding a lack of predictability surrounding central bank policies and also uneasy over a lack of transparency surrounding government policies and the frequent policy shifts surrounding the cash circulation issue. In this environment, there is a significant risk that underlying capital flows into India will deteriorate.
The latest current account data is only available for the three months ending September 2016 and recorded a deficit of 0.6% of GDP. There are expectations that the deficit widened to around 2% of GDP for the December quarter, especially with higher oil prices.
The overall balance of payments position is still relatively comfortable and, at this stage, there is no evidence that India is a target of the US Administration’s trade policies. Any wider deterioration in regional trade growth would still have a potentially important negative rupee impact. A wider dollar depreciation policy could, however, have an important impact in supporting the Indian currency.