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The budget effect on the Rupee

Monday, July 14, 2014

The “authorities’ intention to promote foreign direct investment in selected sectors and initial specific steps to ease rules in defence, insurance and real estate will likely improve international investors’ assessment of India’s macroeconomic policy. These measures boost the authorities’ ability to bridge any short-term current account financing shortfall with new FDI inflows. It also opens up the prospect of an improved economic performance medium-term, which may create the conditions for more Indian rupee (INR) strength further out'” says a report released by Standard Chartered Bank.

According to it “In the short term, however, USD-INR dynamics remain heavily influenced by the Reserve Bank of India’s (RBI) vigorous FX policy. It is not clear that anything in the budget changes the RBI’s trade-offs in this respect. RBI Governor Rajan takes the view that USD-INR in the 60-62 range leaves the INR around “fair value” and the RBI’s calculations of the INR’s real effective exchange rate, based on consumer price inflation clearly support this view.

Data on the RBI’s FX forward book suggest that FX intervention in May was substantial – around USD 20bn (Figure 2). We estimate that June intervention was around USD 7bn and total RBI intervention in recent months could easily have exceeded USD 30bn. Given the scale of this intervention and only modest new budget measures, there is the danger of a short-term lNR liquidation dynamic which would see USD-INR rebound decisively back into the RBI’s “fair value” zone. In the near term, technical resistance based on the 20 March 2014 daily close lies at 61.33.

Given this liquidation threat, we maintain a short-term Neutral recommendation for the INR, but look for opportunities to switch to Overweight on any significant USD-INR correction higher (our end-Q3 USD-INR forecast is at 59.00).

While this first Modi budget may have not brought decisive measures to improve India’s growth/inflation mix, these measures should materialise in coming quarters. Improved inflation news should boost the likelihood that the INR will outperform the considerable depreciation priced into the USD-INR onshore forwards. We retain a medium-term Overweight recommendation and argue that corporate clients hedging overseas FX receivables should look through short-term volatility to exploit the hedging opportunities offered by relatively steep USD-INR onshore forward curves.

The USD-INR 1Y onshore forward, for example, at 64.95 is a full 8.3% above spot and 7.4% above our USD-INR forecast for mid-2015.”

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