Record Low INR: Stability or Imminent Depreciation?

A confluence of factors has fueled recent market volatility. Weaker-than-expected US economic data has ignited concerns about a potential recession, with market estimates now putting its likelihood at 30-35%, a significant increase from less than 10% forecast in June 2024. Adding to the turmoil, a surprise rate hike by the Bank of Japan and the subsequent reversal of yen carry trades added to market uncertainty. The Indian rupee fell victim to this volatility, hitting an all-time low and breaking its previous record of INR 83.5 in October 2022. Although the rupee has weakened in the short term, it has shown relative stability against other emerging and developed market currencies over the past six months.

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INR Performance V/s Emerging Market Currencies (YTD INR Depreciation ~1% v/s other EM currencies ~4-10% Depreciation)

The bigger question is whether the RBI should be concerned about the INR and is there any significant depreciation expected in the near term?

In light of the recent devaluation of the Japanese yen, Chinese yuan, Indonesian rupiah and other emerging and developed market currencies, along with geopolitical tensions, trade wars and tariff fears, there is widespread concern about the possibility of near-term INR depreciation. and its implications for monetary policy. However, we believe the INR will remain stable in the current financial year with no major risk of volatility or depreciation.

This is mostly due to:

Strong macro health: India’s economy has shown remarkable resilience especially in the face of global economic challenges. Key indicators such as gross domestic product (GDP), inflation and fiscal and current account deficits (twin deficits) have seen significant changes over the years. These improvements are the result of a combination of factors including structural reforms, policy initiatives and increased emphasis on economic development. While challenges remain, the resilience of the Indian economy has positioned it as a bright spot in the global economic landscape.

Strong FPI inflows and growth in services: India has witnessed strong Foreign Portfolio Investment (FPI) inflows this year and a growing services sector, with debt and equity investments amounting to around USD 15 billion. This positive trend is attributed to stable economic policies and continuity of governance after the re-election of the current government. The balance of payments (BOP) is projected to maintain a surplus due to several factors. The inclusion of Indian bonds in JP Morgan Indices is expected to attract inflows of around USD 20 billion. Additionally, India’s growing share of global trade, driven primarily by expanding service exports, is boosting the BOP. Additionally, India’s emergence as a global competence center, with more than 1600 multinational corporations setting up their Global Competence Centers (GCCs) in the country, is contributing significantly to the positive economic outlook.

Weak US macros build case for dollar depreciation: Higher fiscal deficit, rising debt to GDP and weak US macro data will lead to a weaker dollar, which will offset any major depreciation and lead to relative INR strength. All major US macroeconomic indicators such as employment, CPI, retail sales showed an overall slowdown in the last quarter. Although the indicators have softened significantly, the US is not expected to enter a recession in the near term.

Build up strong reserves: India has built huge reserves of ~675 bn USD which act as a cushion to avoid near-term volatility and can be used to protect the INR against any major shock.

Recession in China: Market expectations were high from the Chinese Communist Party’s Third Plenum Communiqué to boost consumption growth, but the lack of any big-bang measures has continued to weigh on growth prospects for the economy in the near term.

This has had the effect of weakening commodity prices especially oil, which in turn is beneficial to our currency as it leads to lower import bills.

Impact of Currency on Bond Market and Monetary Policy of RBI

Currency devaluation often triggers a sharp response from central banks. This is mainly due to their dual mandate of maintaining financial stability and controlling inflation. A weakening currency can increase inflationary pressures, prompting central banks to adopt a more restrictive monetary policy stance. Such actions typically depress bond prices, leading to higher yields. By keeping liquidity and monetary conditions tight, the RBI aims to curb inflationary expectations and safeguard currency stability. This trend may temporarily derail the bond market rally and cause some volatility.

To protect the INR against possible depreciation, the RBI is actively using its substantial foreign exchange reserves. However, these interventions may reduce the liquidity of the banking system by putting further pressure on short-term interest rates. Recent data suggests that the RBI has already intervened to the tune of around USD 10-15 billion in the last few trading sessions. To offset the liquidity injected by the inclusion of Indian bonds in JP Morgan Indices, the RBI is expected to conduct open market operations (OMOs) to absorb the excess liquidity. While this measure is likely to be modest, it may temporarily dampen enthusiasm in the bond market. Despite this, overall positive demand-supply dynamics for bonds are expected to prevent significant yield increases.

In the event of a sharp INR depreciation due to global risk-off sentiment or geopolitical tensions, the RBI is likely to maintain a prolonged pause in its rate hike cycle. This trend would deviate from market expectations and could further affect bond yields.

(The author is Dewang Shah Head Fixed Income, Axis Mutual Fund. Views are his own)