In terms of postulates of both Purchasing Power Parity Theory and Portfolio Balance Theory of the exchange rate, the domestic currency is expected to have a depreciating bias. India with a higher rate of inflation is supposed to have slight depreciating bias w.r.t. its exchange rate movement. Apart from this, as per Portfolio Balance Approach narrowing interest rate differential also points towards depreciating bias for USD/INR pair.

However, post fiscally prudent budget, RBI stance change and assembly election result rupee has appreciated considerably; it moved from a high of 68.23 and touched a low of 64.02 in May.

Globally dollar index took a dip in March following a surge in the index post-Trump win as the expectation of Fiscal Policy Stimulus drove the sentiment. But Post March, no guidance from Fed, risk-on sentiment across the globe due to European Election, May announcing Snap Poll,etc. pushed the dollar down. Further, no clear cut guidance from Trump administration on Fiscal Stimulus and Tax cut front apart from Trump’s concern over rising dollar led to fall in the index. The dip led to a surge in other currencies including India.

Domestic Factors behind Recent Rupee Appreciation:

• The post-bjp win in Assembly elections Rupee appreciated as the results were viewed as strengthening Govt hand in accelerating reforms.
• Financial year end book closure also leads to an infusion of funds in equity (to show profits in the books of account) resulting in Rupee appreciation.
• Strong capital inflows, especially, portfolio inflows into equities and, debt markets; and also higher levels of foreign direct investment strengthened the domestic currency. The strength is driven partly by global liquidity and partly by the improving fundamentals of the Indian economy.
• The Reserve Bank of India’s relatively hawkish stance in February 2017 has attracted funds searching for yield.
• A comfortable Current Account position also helped Rupee.

The Balance of Trade also impacts Rupee movement through the interplay of demand and supply. For example, increase in import value of oil either through an increase in physical value or prices deteriorates balance of trade and increases dollar demand putting pressure on the domestic currency. On the other hand, a narrowing trade deficit often led to an appreciation of Rupee, subsequently.

Interest Rate Differential still explains much of Rupee Movement

Though in previous few instances rate cut or easy money policy of RBI was immediately followed by Rupee appreciation by augmenting capital inflows and increasing Dollar sales by FIIs (Foreign Institutional Investors), but this is apparently not the long run behaviour of the pair as can be seen from the above graph. The impact of interest rate differential on Rupee-Dollar exchange rate cannot be neglected. It may be seen from the above, in many instances, a narrowing differential led to Rupee depreciation while increasing differential paved way for Rupee depreciation, but the pace of reaction varies from time to time.

It may be mentioned that, apart from interest rate-growth differential, stability and potential of the economy also plays an important part in determining the strength of the domestic currency.

Why there is Depreciating Bias for Rupee: –

• The Rupee appreciates every March on seasonality, this time the fact that the Dollar weakened in relation to expectations also added to Rupee appreciation. But we think this is going to turn against the Rupee during the next few months.

Rupee Movement-Seasonality!?

In 2015 improving US growth outlook and fundamentals, expectation of Fed normalisation stance, domestic reform agenda not materialising as expected, etc. has kept dollar at an elevated level.   However, the seasonality factor has arrested sharp depreciation during that period.

• US Fed is expected to continue its lift-off to normalise short-term market interest rate and Fed Funds Rate. This apart from US Fed Plan on Reducing Balance Sheet size may push up US Yield further (albeit in a slower pace as recent Fed Minutes showed that balance sheet scale back might not be very fast).Though India’s macro remains stable, interest rate differentials could widen causing INR to depreciate from current levels.
• Typically capital inflows only reflect investors’ perceptions, and that too is of relative nature, they do not constitute “sound economic fundamentals”.
• Trade Deficit is rising. Imports during April 2017 were 49.1% higher in dollar terms and 44.7% higher in Rupee terms over the level of imports in April 2016. Excluding the crude oil, imports during April 2017 were 54.5% higher than non-oil imports in April 2016 in Dollar terms. Exports were higher by nearly 20% compared to a year ago but they were quickly outpaced by the growth in imports. Consequently, merchandise trade deficit in April was 173.5% higher than a year ago in April 2016.
• Local equity market sell-off may trigger a depreciation of the Rupee, as also RBI changing its stance and start talking about faster rate cuts. Another possible reason for a depreciation of the rupee would be the government announcing plans to spend more than expected. With recent farm loan waiver, the Gross Fiscal Deficit (including State finance) is projected to shoot up.
• Another major area of concern is from China Front.

On currency front: we expected that US tax reforms would pass in the second half of this year, which may not bode well for China, which enjoys a very high surplus with the United States.

China Growth Concern: Chinese growth outlook is softened due to the recent tightening of monetary policy by raising the interest rates it charges in Open-Market Operations. While balancing between economic growth and cutting leverage has been an eternal game for policy makers, the latest moves show more willingness to sacrifice growth to control risks (Ref: Bloomberg article)

Weakness in the growth rate of Chinese economy may tarnish overall Emerging Market outlook and also World growth outlook. This may build up pressure on almost all Emerging Market currency.

• Reserve Bank has limited scope to intervene in the foreign exchange market, considering massive liquidity surplus after demonetization. But once it neutralises, Central Bank may again resort to weakening Rupee.

Though the outlook is for Rupee depreciation, it is not going to be similar to the sell off bouts of 2013 as our economic fundamentals are better this time.

During 2013, Rupee depreciation was fuelled by expected taper of quantitative easing by Fed. During Jan-Dec’2013 Rupee depreciated from Rs. 54 per USD to Rs. 61 per USD touching a level of Rs. 68.8. This was accentuated by a deeper decline in Indian Growth Numbers vs. other emerging economies compounded by galloping domestic inflation. Further, a high Current Account Deficit at 6.8% of GDP also restricted RBI to sell dollars to arrest down fall of rupee as it needed dollars to meet CAD. However, by dint of various measures introduced by RBI on external account Sep’13 onwards, Rupee reversed some of the previous downfalls

Though US Fed and other Central Banks’ tapering is expected, this time the rupee may not depreciate steeply like that of Sep’13 mainly as India’s fundamental is better off now vis-a-vis Sep’13. Inflation is benign, CAD is only around 1.4% of GDP, and there is structural improvement in the economy for,e.g., implementation of GST.

Low inflation expectations, high real rates, high political equity make Indian Rupee attractive. Given the same, in near term despite a depreciating bias in Rupee, the pair may hold historical high within a horizon of three to six month.