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Rupee to continue to outperform its peers

Monday, October 03, 2016
By Anindya Banerjee

Anindya Banerjee Currency Derivatives Researcher, Kotak Securities

Rupee continues to outperform its peers, barring the one day snap decline that happened last week on account of military operation conducted by Indian armed forces against terror camps in PoK. Indian currency is an interplay of domestic and global macro and micro forces. Domestic script would continue to remain supportive for Rupee as reforms and better policies improve long term growth potential. Current account is in near balance, inflation remains low, public investment is being better targeted and efforts are being made to increase the size of the official economy over the black economy.
The next big challenge in front of policy makers is the rollout of Goods and Services Tax, scheduled for next calendar year. It is one of the biggest reform initiative undertaken in post-Independence era and if done properly, it can not only reduce cost of doing business but also augment government revenues. However, there will be losers, as there is always with any reform, in this case the players in the unorganized sector who were surviving on tax arbitrage. Apart from the tax reform the next big challenge for the government is creation of well-paying jobs in the economy. Construction sector and real estate sector is going through a cyclical downturn and the sector employs large number of semi-skilled and unskilled workers. India’s manufacturing sector is not in a position to absorb those people displaced from the real estate sector.  

Though Indian Rupee would continue to outperform its peers but its value against US Dollar is always a function of global headwinds and tailwinds. Global economy continues to weaken and so is global trade. The World trade Organization cut its forecast for global trade growth this year by more than a third on Tuesday, reflecting a slowdown in China and falling levels of imports into the United States. The new figure of 1.7%, down from the WTO's previous estimate of 2.8% in April. This will be the first time in 15 years, the WTO says, that the ratio between trade growth and world gross domestic product (GDP) has fallen below 1:1; it will be around 1:0.8. Several wild cards could spook the outlook, the WTO says. Monetary policy changes in developed countries could lead to financial volatility, for one. The Brexit vote in the United Kingdom, it notes, has also increased uncertainty about future trading arrangements in Europe. And there’s the growing trend towards protectionism across the globe.

Before I sign off let me touch upon outlook for Rupee over the near term. RBI monetary rates are an interplay of retail level inflation and state of slack in the economy. In its last monetary policy, RBI had sounded cautious in its outlook on inflation as dis-inflationary impact of a good monsoon was not yet fully known. However, since last monetary policy in August, trend of retail inflation has surprised on the downside. CPI for August came in at 5% from a 22-month high reading of 6.1% in July. Expectation of bumper kharif harvest is causing prices of cereals and pulses to decline. We expect the food and fuel inflation to have a dampening effect on the headline for rest of FY17. As a result, the headline inflation may drop further towards 4.00/4.2%, as high base of last year also plays out. From inflation as we shift our focus to growth. Industrial production fell 2.4%YoY in July with deceleration across manufacturing, mining and electricity. From the demand side, capital goods production fell ~30%YoY, a 9th straight month of contraction. Weak growth and low inflation has opened up the possibility for reduction in interest rates in October, by 25 bps. A possible rate cut can have positive impact on India's bond prices, where we continue to remain bullish, with new 6.97% GOIsec 10 year expected to hit 6.68/6.70% over the near term. Indian Rupee is expected to strengthen if RBI lowers rates, towards 66.25/30 levels on spot from 66.63 currently. However, RBI intervention would prevent any sharp appreciation of the Rupee.

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