The Indian rupee (INR) has traded near record lows against the US dollar (USD) in recent months despite rapid economic growth and strong levels of optimism surrounding the Indian economy. At time of writing, the rupee is trading at 82.84 against the dollar – just shy of its record low of 83.29. Will the rupee move away from this unprecedented weakness, or will further declines be in store for rupee markets?
The rupee hit record lows last year for similar reasons to many emerging market currencies – the strength of the US dollar. With inflation peaking at over 9% in the United States, the Federal Reserve moved over the course of last year to hike rates significantly, to a three-decade high of 5.5%. This encouraged foreign exchange traders to reduce their exposure to relatively high-risk currencies such as the rupee, and into the US dollar, which was seen to be both safer and offering relatively lucrative yields.
The Reserve Bank of India (RBI) intervened in foreign exchange markets in a bid to stem the declines on rupee markets. There is a debate amongst economists about whether this is the right approach to India’s currency – some argue that a cheaper rupee would help Indian manufacturers become more competitive on international markets and therefore spur even higher growth.
However, the global asset management firm Abrdn suspects that the RBI, which is equipped with over $600 billion in foreign reserves, is keen to keep losses to a minimum in order to avoid increasing inflation. After all, India runs a sizeable trade deficit of over $17 billion a month and is dependent on imports for many essential goods such as chemicals, fertilisers, and plastics, as well as oil.
Given many of these goods are priced in dollars, a weaker rupee would make them more expensive in local terms and therefore potentially lead to higher inflation. Indeed, India is already seeing higher prices, with inflation currently over target at 5%. Kenneth Akintewe, Head of Asian sovereign debt at Abrdn Asia, therefore said that intervention in currency markets “makes sense.”
“Why build up one of the world’s largest reserves if you are not going to use them? We are also in a world of elevated oil prices among other commodities, and undue depreciation will lead to imported inflation, which will make it harder to get back to the 4% target.”
While potentially a wise decision to manage inflation, this intervention could have ramifications on forex markets this year. The US dollar is expected to weaken on foreign exchange markets this year as the Fed gradually eases off interest rate hikes and potentially begins to move towards monetary easing. Lower yields in the US should incentivise traders to seek higher yields elsewhere. In theory, this should give emerging market currencies more space to make gains against the dollar.
However, this is unlikely to play out on rupee markets because the Indian currency is already overvalued relative to the dollar thanks to the intervention of the central bank. A weaker dollar is therefore unlikely to lead inevitably to a stronger rupee, as may be the case with other emerging market currencies.
That said, some analysts believe that other factors could prompt the rupee to strengthen on foreign exchange markets this year. For example, Tan Teck Leng of UBS Global Wealth Management has said that the rupee is “one of our favourite currencies to play the yield carry trades this year” because of the fact that INR has traded in such a tight trading range.
Carry trades are a type of strategy which involve borrowing in a cheap currency, such as the rupee, and using this as a way of buying higher-yielding assets. Strong demand for the rupee for carry trades could lead to higher capital influxes on INR markets and therefore a higher rupee price.
Higher capital influxes could also come because of the increased interest foreign investors are taking in Indian financial markets. With India rising to become the world’s fifth largest economy, its financial markets have grown in turn, with India’s National Stock Exchange (NSE) now the world’s largest derivatives exchange by number of contracts traded, and with a market capitalisation of well over $3 trillion.
Earlier this year, the Indian stock exchange briefly overtook Hong Kong’s market as the fourth biggest equity market in the world. While Indian markets remain dominated by domestic markets for now, unsurprisingly more international hedge funds and financial institutions are seeking greater exposure to India. This trend could accelerate this year, with many investors with an exposure to Asia rotating assets out of China, given the perception of Beijing’s economic troubles, and into other Asian markets such as Tokyo and New Delhi.
Should more foreign investors enter Indian markets this year – whether for the purpose of conducting carry trades or purchasing Indian equities – this would require more investors to purchase the Indian rupee, potentially pushing up its value. However, it remains to be seen to what extent the rupee is currently overvalued owing to the intervention of the central bank and therefore the extent to which the currency moves in response to this year’s developments.
Author: Harry Clynch
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