The year 2017 was a memorable one for the Indian rupee. The domestic currency snapped six consecutive years of decline against the US dollar and strengthened over 6 per cent to close the year on a strong note. But things have turned around in 2018. From one of the best performing emerging currency in 2017, the rupee has become one of the worst performers. The currency is down over 2 per cent against the dollar so far this year. This is despite the fact that the US dollar index has been broadly range-bound this year after having fallen sharply by 10 per cent in 2017.
Three major factors pushed up the rupee in 2017. The first trigger was the resounding victory by the ruling Bharatiya Janata Party (BJP) in the Uttar Pradesh (UP) State elections in March. It helped the rupee breach 66 and strengthen towards 64 by April. The level of 66 was then a critical hurdle that had restricted the rupee through 2016.
The second factor that helped to strengthen the rupee last year was the strong inflows from foreign portfolio investors (FPIs) into the Indian debt segment. Relatively higher yield on debt, seem to have attracted FPIs. The month of March alone witnessed an inflow of $3.92 billion into the debt segment. The calendar year 2017 attracted a robust $23 billion. This is the second highest inflow witnessed in any year from the data available since 2002; the highest were recorded in 2014 with an inflow of $26.25 billion.
Thirdly, it was the sustained weakness in the US dollar all through 2017 that kept the rupee stronger all through the year. Incidentally, the free fall in the US dollar that began in early March also coincided with the UP State election’s outcome. The dollar index tumbled over 12 per cent from around 104 in January to a low of 91 in September.
So, what has changed in rupee fundamentals this year? We take stock of the country’s macros to gauge where the currency is headed.
Widening current account deficit (CAD) remains a worry. India’s CAD widened to $13.48 billion in the quarter ending December 2017 from $7.23 billion in the previous quarter (September 2017). The deficit for the same period in the previous year was $7.92 billion.
Bulging merchandise trade deficit — the major component in the current account — has been keeping the CAD under pressure. According to the data from the Ministry of Commerce, exports in the fiscal year 2017-18 (FY18) have increased 10 per cent to $302.84 billion . Imports, on the other hand, have increased at a much faster pace of 20 per cent in the same period to $459.6 billion. This has taken the trade deficit wider to $156.8 billion in FY18 from $108.9billion in FY17. Two major components — surging crude oil prices and increase in gold imports — can continue to keep the import bills higher, thereby retaining pressure on the trade deficit.
Crude oil prices have been surging since last June. The West Texas Intermediate (WTI) Crude Futures contract skyrocketed over 55 per cent from around $43 per barrel to the current levels of $67. The Organisation of Petroleum Exporting Countries (OPEC) deciding to extend the production cut until end-2018, coupled with the geo-political risks, are supporting the crude oil price rise in the recent times. According to the International Energy Agency (IEA), oil demand is expected to increase to 99.3 million barrels per day (mb/d) in 2018 from 97.8 mb/d in 2017. The market is expected to run into a deficit in the second half of this year. There is, thus, a strong likelihood of the oil prices increasing further towards $76 per barrel in the coming months, owing to these factors.
Similarly, gold is also gaining sheen on the back of a weak dollar and from the on-going trade war concerns between the US and China. Gold imports are inching higher after having fallen over the previous two consecutive fiscals. India has imported $28.26 billion worth of gold in FY18 (April-January) surpassing the $27.45 billion imported in the entire FY17. Gold prices remaining stable in a broad range between $1,200 and $1,300 per ounce in the first half of 2017 coupled with dealers beginning to restock after recovering from the impact of cash crunch due to demonetisation, saw the bullion imports surging.
Though gold prices are broadly range-bound between $1,300 and $1,370 since the beginning of 2018, there is high possibility of the yellow metal surging towards $1,450.
On an average, oil contributes 25 per cent of India’s total imports and gold accounts for 8 per cent. A strong surge in these commodity prices will take the import bills higher which, in turn, could widen the deficit further. This is a negative for the rupee.
Debt and reserves
India’s external debt is another concern, given that the global interest rate cycle is reversing higher. External debt has been rising consistently over the last year. As on December 2017, the total external debt was $513.4 billion, up over 12 per cent from $456 billion the previous year.
Long-term debt accounts for about 81 per cent and short-term debt 19 per cent. Though record forex reserve build-up of $424 billion can come to the rescue, increasing debt will continue to be a concern. The country’s forex reserve can now cover about 10 months of imports.
The Real Effective Exchange Rate (REER) indicates that the rupee is highly over-valued. As on March 2018, the 6-currency trade weighted REER was at 124.56 and the 36-currency trade weighted REER at 117.38. An over-valued REER increases the possibility of the rupee weakening in the coming months.
REER is a measure of valuing a currency against the currencies of its trade partners. A currency is considered overvalued if its REER is greater than 100 and undervalued if the REER is below 100.
Elections and foreign money
A major event that could increase the rupee’s volatility, going forward, is the Lok Sabha elections in 2019. In the one year period before the elections in 2009 and 2014, the rupee depreciated 20 per cent and 9 per cent respectively.
However, these election years were preceded by key events such as the global financial crisis and the US beginning to taper quantitative easing. These were the major causes for the rupee depreciation during this period.
But the outcomes of the assembly elections in Karnataka (in May), Madhya Pradesh and Rajasthan will be a key sentiment driver for the financial market and may also influence foreign money flows into the country. After record inflows in 2017, the FPI money inflow has lost pace this year. The FPIs have brought in just $700 million in debt this year.
An outcome against the ruling BJP in the State elections will increase the risk of the FPIs pulling money out of the country that could be negative for the rupee.
Given all the macro-economic indicators, the domestic factors seem to be unfavourable for the rupee.
Higher oil and gold prices may further widen the deficit. Increasing debt and over-valued REER are likely to weaken the rupee and drag it down in the coming months.