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Currencies: Indian Rupee Vulnerable to Equity Outflows

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PICTET WEALTH MANAGEMENT FLASH NOTE ASSET ALLOCATION & MACRO RESEARCH 19 May 2021 CURRENCIES: INDIAN RUPEE VULNERABLE TO EQUITY OUTFLOWS SUMMARY Author › We see the Indian rupee as highly sensitive to foreign investment flows into Indian LUC LUYET equities. Our relatively conservative economic growth outlook suggests that those [email protected] flows may abate in the next months. › Because of high underlying inflationary pressure, the Reserve Bank of India could prove less active than before in the FX spot market as the purchase of foreign exchange increases the monetary base if not sterilised. That said, large FX reserves also make any sharp depreciation of the rupee unlikely. › Our projections for the USD/INR rate are: INR74.5 in three months, INR75.5 in six months and INR76.0 in 12 months. A growth-sensitive currency The Indian rupee outperformed most other EM currencies from the start of the year until well into March. But at the end of March, the sharp deterioration in the covid-19 situation in India led to downward pressure on the rupee. The rupee lost roughly 4% relative to the US dollar, moving from INR72.4 on 22 March to INR75.4 on 21 April, underperforming most other EM currencies. The rupee has strengthened again since then, notably because the Indian government resisted imposing a national lockdown, which would have had a dire impact on the Indian economy. Overall, this confirms that a key factor for the Indian rupee is the domestic growth outlook. In particular, a strong outlook favours investment flows into India (especially into Indian equities), providing significant support to the rupee. CHART 1: USD/INR VS. NET PORTFOLIO INVESTMENT FLOWS INTO INDIAN SECURITIES 1 USD in INR (y-o-y as %) Net portfolio investment inflows (4q sum, inverted scale) USDbn 25 -20 20 -10 15 0 10 10 5 0 20 -5 30 -10 40 -15 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 Source: PWM - AA&MR, Refinitiv, 18 May 2021 Because of the pandemic, the Reserve Bank of India (RBI) has remained focused on supporting economic activity through an accommodative monetary policy stance, disregarding above-target inflation in 2020. As inflationary pressure has abated this year, 1 OF 6 FLASH NOTE PICTET WEALTH MANAGEMENT ASSET ALLOCATION & MACRO RESEARCH 19 May 2021 CURRENCIES: INDIAN RUPEE VULNERABLE TO EQUITY OUTFLOWS it is likely that the RBI will remain accommodative in the next few months. But while efforts to support the economy should help the rupee, other RBI’s actions may not. Notwithstanding low real interest rates, the RBI has been accumulating FX reserves over the last 12 months, limiting the rupee’s appreciation. That said, high inflation and the already large amount of liquidity in the system limit the ability of the RBI to intervene much further on the spot market, as it increases the monetary base if not sterilised. In February, the RBI intervened aggressively by purchasing large amounts of US dollar. But since its purchases were in the form of forward contracts, they led to a significant rise in the USD/INR forward premium, which may have ultimately weighed on the US dollar by lowering importers’ demand for hedging their currency exposure and higher short-term carry-trade inflows. Despite the RBI’s large USD purchases in recent months, the central bank is unlikely to tolerate excessive rupee weakness because of the risk of stoking imported inflation. Given its large FX reserves, the RBI has enough fire power to smooth any decline in the rupee. Indeed, March saw the RBI selling some of its FX reserves. Overall, our expectation is that Indian inflation will remain relatively high —most likely above the RBI’s 4% inflation target and perhaps even close to the top of its tolerance band (6%). This may limit the RBI’s ability to curb the rupee’s appreciation or even its toleration of any sharp depreciation of the currency. Reduced FX interventions could make the currency even more sensitive to balance of payments flows. CHART 2: THE RESERVE BANK OF INDIA’S FX INTERVENTIONS FX Interventions (Purchase - Sale) of USD FX Interventions monthly net forward purchase of USD USD/INR USDbn 80 Sale of USD -30 75 -20 70 65 -10 60 55 0 50 10 45 40 stronger INR 20 35 Purchase of USD 30 30 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 Source: PWM - AA&MR, Refinitiv, 18 May 2021 Balance of payment flows likely to turn less supportive Due to a current-account surplus (thanks in large part to a decline in imports) and foreign interest in Indian equities, capital flows have been supporting the rupee in recent quarters. But as the economic situation normalises, the current account is expected to move back into deficit. We have a more conservative view on India’s economic activity than consensus, believing the recent surge in covid-19 cases in India will delay some government growth initiatives. 2 OF 6 FLASH NOTE PICTET WEALTH MANAGEMENT ASSET ALLOCATION & MACRO RESEARCH 19 May 2021 CURRENCIES: INDIAN RUPEE VULNERABLE TO EQUITY OUTFLOWS While foreign investment flows have held up during the latest surge, risks to the economic outlook may ultimately weigh on foreign capital flows. Overall, balance of payments dynamics should offer less support to the rupee in the coming months. It is also worth highlighting that the fiscal year 2021 budget (which goes from 1 April 2021 to 31 March 2022), which will likely lead to a further deterioration in India’s fiscal balance, has not sparked concern among investors. Confidence in India’s growth potential and foreign investors’ interest in Indian equities are likely part of the explanation for this. This tends to suggest that the outlook for Indian growth is decisive for the rupee and that any growth disappointment because of the latest covid surge could weigh on the currency. Overall, we would not expect the rupee to appreciate much further, as capital flows are likely to decline in the coming months, especially if the fall in covid-19 cases is slow and weighs on economic recovery. At the same time, we see limited scope for a significant depreciation of the rupee in light of elevated inflationary pressure. Our projections for the USD/INR rate are INR74.5 in three months, INR75.5 in six months and INR76.0 in 12 months. CHART 3: INDIA CURRENT ACCOUNT, FDI AND PORTFOLIO INVESTMENT (AS % OF GDP) Current account (4q sum) FDI (4q sum) Portfolio investment (4q sum) Total 6 4 2 0 -2 -4 -6 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 Source: PWM - AA&MR, Refinitiv, 18 May 2021 3 OF 6 FLASH NOTE PICTET WEALTH MANAGEMENT ASSET ALLOCATION & MACRO RESEARCH 19 May 2021 DISCLAIMERS Distributors: Banque Pictet & Cie SA, Route des Acacias 60, 1211 Geneva 73, Switzerland, Pictet & Cie (Europe) S.A., 15A, avenue J. F. Kennedy, L-1855 Luxembourg/B.P. 687, L-2016 Luxembourg. Banque Pictet & Cie SA is established in Switzerland, exclusively licensed under Swiss Law and therefore subject to the supervision of the Swiss Financial Market Supervisory Authority (FINMA). Pictet & Cie (Europe) SA is established in Luxembourg, authorized and regulated by the Luxembourg Financial Authority, Commission de Surveillance du Secteur Financier. 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