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Rupee strength reflects positive dynamics in India, says Dushyant Padmanabhan

LiveMint logoLiveMint 09-06-2017 Joji Thomas Philip

Singapore: The strength of the rupee reflects a number of positive dynamics in India that extend beyond the well-telegraphed high growth and controlled inflation. It also reflects factors such as the union budget adhering to fiscal consolidation, the outcome of the Uttar Pradesh state polls and its implications for the 2019 general elections and continued progress on important reforms such as the Goods and Services Tax (GST), Dushyant Padmanabhan, a currency strategist at Nomura Holdings Inc. in Singapore, said in an interview.

Padmanabhan said a competitive currency could help exports, but pointed out that it was only one of the many factors that determined overall export competitiveness.

“We also have to consider other factors such as productivity, the ease of doing business, logistical constraints and so on. In this regard, developing countries would benefit from a targeted approach to develop or encourage particular sectors for exports, perhaps similar to Singapore or Korea in their early years of economic development or the Make in India initiative,” he added. Edited excerpts:

RBI has kept the repo rate unchanged and it also cut inflation projection. What is your take?

We agree with the assessment that headline inflation will remain low in the near term due to low food prices on improved supply, particularly in pulses and vegetables. Core inflation is also suppressed due to lingering effects of demonetisation and the negative output gap. Our view is that the ongoing remonetisation and easier financial conditions support a cyclical growth recovery in the second half of the year which could help alleviate the disinflationary pressure on core inflation. It remains to be seen whether the RBI will view this as a transitory, warranting no adjustment or if this leads to another rate cut although market expectations of a cut have increased. For FX markets, further accommodative policy can be supportive of inflows and consequently INR; however we have to be wary of external risks, particularly with the next Fed hike and potential discussions around balance sheet adjustment around the corner.

What do you read from the Reserve Bank of India’s monetary policy committee turning down a finance ministry invite before the rate meeting?

It is difficult to say without knowing the exact circumstances, but I would say that at this juncture the market views RBI as independent, particularly after the appointment of an internal candidate in Urjit Patel to replace (Raghuram) Rajan and the switch to a monetary policy committee, which dilutes any potential influence from a single member.

With a Fed rate hike looming, which of Asia’s currencies do you think will be the worst affected? How would the INR likely react?

Fed risks to the region have somewhat diminished as a hike at the next meeting this month is widely expected by the market. One risk from this meeting would be if there is further discussion of Fed plans to shrink their balance sheet. This could lead to higher US Treasury yields which would have a particularly negative implication for bond-sensitive currencies in Asia, such as Indonesia and Malaysia where foreign bond holdings have been relatively high. That said, the risk is that discussions around Fed balance sheet tapering could percolate into broader risk aversion and some equity market weakness, which could also affect equity-sensitive currencies such as Korea, Taiwan and, indeed, India. However I believe that in this scenario investors could focus on differentiating domestic dynamics – including the growth outlook, relative interest rates, FX policy, and so on – which would favour INR. While USD/INR would likely trade higher, in line with broader US$ strength. Longer-term investors could use this opportunity to add to their bullish India positions, while RBI could also act to limit volatility. Overall, India is not immune from the impact of the Fed - however it is relatively better positioned and INR can still be an outperformer in this scenario.

Is a stable and appreciating currency one reason why foreign investors are buying Indian bonds and equities?

Most certainly. Currency risk is a significant consideration for foreign investors, so stability – particularly given the high cost of hedging through buying USD forwards – is an important factor. Beyond the impact on returns, I think FX stability can add to a self-reinforcing cycle of inflows as FX is often looked at as a barometer for broader macro conditions. Looking ahead in the longer run, supply-side reforms in particular will matter for FX because these would lead to productivity gains and diminish concerns around valuation and competitiveness. These sentiments have been echoed both by former RBI governor Rajan and of late, the government.

Is the rupee strength justified? What do you attribute the rupee’s near term strength to?

Yes, I think the rupee strength reflects a number of positive dynamics in India. Beyond the well-telegraphed high growth and controlled inflation, there have been a few specific catalysts that have added to the India story off late. Prominent ones would include the budget in February and its adherence to fiscal consolidation, as well as the UP state election and its implications for the 2019 general elections, while we have also seen continued progress with important reforms such as GST. Besides this, INR strength versus the USD this year has also been driven by broad USD weakness, which in turn has been driven by a number of factors including a diminution of market concerns around US policy and synchronised global recovery.

Will the tide turn once rupee weakens?

Well, it depends on why the rupee has weakened – and whether this is being driven by domestic macro or policy concerns or global developments. If INR is weakening in line with regional currencies due to concerns around the Fed, US policy or other exogenous factor, we would expect INR to still outperform in this scenario as RBI intervenes to address market volatility. Furthermore, if the domestic growth story remains intact, foreign investors could return once the initial shocks have subsided. The bigger risk would be if there is any reason to doubt the ongoing reform agenda, increased political risk or a significant cyclical slowdown in growth.

We have seen masala bonds reviving—is a strengthening rupee also the reason why global investors are buying masala bonds? (Masala bonds are rupee-denominated bonds sold overseas.)

I think the recent success of masala bond issuance has been in part due to more investors seeking exposure to the India story, and rupee stability certainly helps. Of course, the relatively easier access to this market and government support also helps. Beyond that I think it’s also important to be aware that the general investment environment for EM (emerging market) assets has improved this year, and India is among the most attractive stories in this space, so it makes sense that demand for India risk/assets has increased.

Are you seeing the difference in the way which Urjit Patel is handling the currency - is the focus more on letting the market decide the exchange rate? Is this good for India at this juncture?

Make no mistake – RBI has actually been quite active in intervention in recent months. In March and April RBI bought nearly $15 billion in spot and forwards; however there were equally material inflows of $11.8 billion into stocks and bonds in the same period, as well as inward FDI (foreign direct investment) of $3.8 billion in March alone. Hence it appears that RBI remains active in the market, but the magnitude of move we saw in that period in particular – with INR appreciating by 3.8% versus the USD – is also a function of the large inflows that we saw. So what we are seeing in general is that RBI remains active in the market, but still seems to be allowing currency appreciation. With India’s relatively strong macro position, an already sizeable accumulation of FX reserves and positive sentiment towards India, RBI is in an ideal position to allow for more market determination while adhering to their policy of limiting market volatility. More market determination would improve FX policy credibility while diminishing concerns over currency manipulation, which has been a worry for some countries since Donald Trump took office. At this juncture, as the domestic economy is looking relatively supported, INR appreciation is attracting foreign investment which is good for the country.

Will the China downgrade dent Asia’s currencies?

It appears to have had a contrary effect - we think that the Moody’s downgrade could have been one of the catalysts for authorities in China to aggressively address market depreciation expectations, delivering the strong appreciation we have seen in recent days. This has percolated to a number of currencies in the region and led to some Asia FX appreciation as further RMB (renminbi) depreciation risk was effectively taken off the table for the time being. However, beyond this near-term impact, continued deterioration in China’s credit and growth outlook would definitely have a negative impact on Asian currencies. We expect China growth to slow further to from 6.7% in 2017 to 6.2% in 2018, as the property sector loses steam after intensive policy tightening.

India at present may not be facing headwinds or a competitive disadvantage in a big way as other countries, including China, are not actively seeking to depreciate their currencies. But will this be an area of concern going forward?

At this juncture a competitive devaluation by any major economy seems unlikely because of the increased focus on FX manipulation by the Trump administration, and the criteria to designate countries as currency manipulators as laid out by the US Treasury. Nonetheless, if India’s competitors choose to deliberately pursue a weak currency policy, this might only have a limited impact, for a number of reasons. First off, we should note that India’s REER (real effective exchange rate) has moved by 15% in the past 3 years yet the overall economy has been quite resilient. This is because India’s domestic consumption has held up quite well, notwithstanding the effects of demonetization. That said, if regional or EM currencies do depreciate versus the USD, then INR should also depreciate, assuming the RBI policy of allowing market determination – while limiting volatility – remains in place. Indeed, given the adequate FX reserves of the RBI, they could remain active in the market to smooth INR price action in an EMFX (emerging market forex) depreciation scenario, which would lead to INR outperformance and a loss of currency competitiveness. However, as has been highlighted both by previous RBI governor Rajan and the government, this is only one factor in considering the overall competitiveness of India’s exports. INR valuations appear more attractive once you account for India’s relative productivity gains, and continued progress on this front would diminish these competitiveness concerns.

What is your take—do poor or developing countries like India need the help of cheap currencies to break into export markets?

Certainly, a competitive currency can help; but only to a limited extent. Currency is only one factor in determining overall export competitiveness – we also have to consider other factors such as productivity, the ease of doing business, logistical constraints and so on. In this regard, developing countries would benefit from a targeted approach to develop or encourage particular sectors for exports, perhaps similar to Singapore or Korea in their early years of economic development or the ‘Make in India’ initiative. Addressing bottlenecks in developing these sectors while providing the regulatory and financial support and providing a well-educated and well-trained labour force could arguably have a greater impact on boosting exports in the long run than currency competitiveness.

RBI has kept the repo rate unchanged and it also cut inflation projection—what is your take?

We agree with the assessment that headline inflation will remain low in the near term due to low food prices on improved supply, particularly in pulses and vegetables. Core inflation is also suppressed due to lingering effects of demonetisation and the negative output gap. Our view is that the ongoing remonetisation and easier financial conditions support a cyclical growth recovery in the second half of the year which could help alleviate the disinflationary pressure on core inflation. It remains to be seen whether the RBI will view this as a transitory, warranting no adjustment or if this leads to another rate cut although market expectations of a cut have increased. For FX markets, further accommodative policy can be supportive of inflows and consequently INR; however we have to be wary of external risks, particularly with the next Fed hike and potential discussions around balance sheet adjustment around the corner.

What do you read from the Reserve Bank of India’s Monetary Policy Committee turning down a finance ministry invite before the rate meeting?

It is difficult to say without knowing the exact circumstances, but I would say that at this juncture the market views RBI as independent, particularly after the appointment of an internal candidate in Dr. Urjit Patel to replace Dr. Rajan and the switch to a Monetary Policy Committee which dilutes any potential influence from a single member.

With the Fed looming, which of Asia’s currencies do you think will be the worst affected? How would INR likely react?

Fed risks to the region have somewhat diminished as a hike at the next meeting this month is widely expected by the market. One risk from this meeting would be if there is further discussion of Fed plans to shrink their balance sheet. This could lead to higher US Treasury yields which would have a particularly negative implication for bond-sensitive currencies in Asia, such as Indonesia and Malaysia where foreign bond holdings have been relatively high. That said, the risk is that discussions around Fed balance sheet tapering could percolate into broader risk aversion and some equity market weakness, which could also affect equity-sensitive currencies such as Korea, Taiwan and, indeed, India. However I believe that in this scenario investors could focus on differentiating domestic dynamics – including the growth outlook, relative interest rates, FX policy, and so on – which would favour INR. While USD/INR would likely trade higher, in line with broader US$ strength, longer-term investors could use this opportunity to add to their bullish India positions, while RBI could also act to limit volatility. Overall, India is not immune from the impact of the Fed - however it is relatively better positioned and INR can still be an outperformer in this scenario.

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