What is the fair value of Rupee? 65, 75 or 80?

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The recent steep depreciation of the Rupee has created headlines. Though the up move in USD/INR has been swift, there is no real reason for alarm as Rupee has just depreciated in line with weakness in the broader EM basket. On Year-To-Date basis, the Rupee has depreciated ~10% while comparable currencies such as the Indonesian Rupiah and the Philippine Peso have depreciated 8.2% and 6.7% respectively. Rupee simply reacted more as it had more catching up to do. When the broader USD sentiment turned around, Rupee was late to react. Despite the recent weakness, the Rupee still continues to remain overvalued in REER (Real Effective Exchange Rate) terms.



A USD/EM or USD/Asia move is not uncommon during a US rate hike cycle when shorter end US rates start heading northward (Refer to our article published in May where we had highlighted upside risks to USD/INR with a target of 71-72). The unwinding of carry-trades and a concerted exodus of hot money causes sharp moves. The ongoing trade tensions between the US and China have dented risk sentiment globally. The People’s Bank of China has used Yuan devaluation as a tool to offset the trade tariffs imposed by the US and to keep their exports competitive. The weakness in the Yuan has spilled over to other Asian and EM currencies. In addition, sanctions on Turkey and the economic crisis in Argentina have further exacerbated the move in the EM space.


Elevated crude prices have also dampened the outlook on the current-account front. Among stable economies, the ones running a current account deficit have seen sharper moves. When the crude prices were lower, our economy witnessed a positive terms of trade shock and this caused the Rupee to appreciate relative to the other currencies. However, the relative appreciation of the Rupee is detrimental to our exports. The elasticity of our exports to Rupee is high as our exports can be substituted by exports from other countries. This explains why our exports have underperformed despite strong global growth over the last couple of years.


This phenomenon wherein one sector of the economy benefits at the expense of the other is referred to as the Dutch disease. Moreover, a stronger Rupee also hurts domestic industries as imports become cheaper in relative terms. The fact that the Rupee overvaluation is now getting corrected in REER terms is actually positive for our exports and domestic industry. Exports contribute 20% to our GDP, and it is a major employment generating sector.



The recent steep move in the Rupee has caused some nervousness among importers and corporate with unhedged foreign currency borrowing. Many importers were compelled to take stops above the 70 mark, and this too has contributed to the Dollar demand. Seasonality has been against the Rupee as well. August has historically been a weak month for the Rupee. Defense related outflows also typically happen during this time of the year.


Though the REER has corrected from 122 to 114 since January, a further 3-4% up move in USD/INR cannot be ruled out over the next 3-4 months if further panic in the EM markets continues*. A developing economy witnessing productivity growth is likely to see its currency appreciate in real terms according to the Balassa- Samuelson framework. At a REER of around 108-109, the Rupee would actually be considered fairly valued. There are several triggers on the global and domestic front for such a move to materialize. The major risk events on the global front are developments on trade-related negotiations between US and China, the FOMC September policy, US mid-term elections in November. Whereas in domestic front it is elevated crude prices which can put pressure on twin deficit and correction in equity indices (Trading at historical high valuation of 28 PE multiples) are something to keep a close eye on. While the US Fed is expected to hike rates by 25bps in September and December, more clarity will emerge on the pace of hikes in 2019 in the September policy. In last meeting, the Fed committee indicated 3 hikes for 2019, whereas market is factoring less hikes. The summary economic projections of the committee will be watched closely, particularly as Fed chair Powell had undermined risks of an inflation overshoot in his Jackson Hole speech.


The Rupee could underperform its EM peers if crude prices remain elevated. Markets are pricing in a 75% probability of another 25bps hike by the RBI in the October policy. It will be interesting to see if the RBI changes its policy stance. The RBI has managed the Rupee well thus far. It has intervened in the OTC as well as exchange-traded markets to contain volatility and keep speculators at bay to prevent a repeat of 2013 like situation. It was only in the most recent leg of up move that the volatility has spiked up (It is difficult to recall a previous instance when the Rupee and the Equities have trended in opposite directions for so long. Throughout the Rupee up move, there has been no panic in Equities and that could partially explain the low vols). 1M ATMS vols have risen from 4.80% to 6.30% since 10th August**.


The farther end of the vol curve has not moved much at all, causing the vol curve to become flat. RBI’s Reserves have been drawn down from a peak of USD 426Bn in April to USD 401Bn now. Managing liquidity would be a challenge for the RBI. Continued FX intervention, corporate advance tax outflows and festive season related currency demand could suck out liquidity from the banking system. The RBI would have to re-infuse the liquidity through sizeable OMOs. There are risks on the fiscal front as well. The GST revenues have been undershooting expectations. The government has already reached 86% of its budgeted fiscal deficit target by July itself. Though this is generally the case as expenses are front loaded and receipts back-loaded, this year could be different as the government can ill afford to clamp down on spending, heading into an election year and indirect tax collections and divestment proceeds are likely to remain tepid. Any fiscal slippage would be viewed negatively by FPIs and could spook the bond markets.


Considering the fact that there is still some steam left in this Rupee up move, it would be prudent for exporters to hedge medium-term exposures by selling risk reversals so that they can retain participation in case the move plays out. (Buying Puts and Selling Calls). 1M 25d RRs have risen from 0.5% to 1.1% since the start of August and this would offer decent participation on the upside. On the other hand, Importers can look to hedge through long side seagulls.



*(Considering the base year as 2006, when the Rupee was hovering around the 44 mark, if we consider average inflation differential between the US and India at 4.5%, the fair value of the Rupee should be around 75.




The correlation between Nifty and Rupee has simply distorted today. A big fall in Nifty seems inevitable looking at extreme valuations and the way MSCI index is behaving, which possibly could be become the next trigger for Rupee weakness.




The span from 2006 to 2018 is a fairly long period and encompasses periods of calm as well as turmoil. We have seen three major panic moves in this time frame i.e. in 2008, 2011 and 2013. The Rupee should broadly track the inflation differential. However, there are times when the Rupee can deviate significantly from its fair value on either side and those deviations can persist for prolonged periods.)




**(To make sense of the relative panic in EM space, while the 3M vols in IDR have risen from 6.5% to 11.5% since 10th August, 3M INR vols have merely risen from 5.2% to 6.2%. INR vols are still much lower compared to CNH, KRW and IDR)




(Also, in 2008, when the Rupee had spiked from 39 to 52, the high seen on 1M ATM (at the money)vols was 25%, when it spiked from 44-53 in 2011, 1M ATM vols saw a high of 12%, in 2013, when the Rupee spiked from 54-69, the high seen on 1M ATM vols was 20%. However this time around, though the Rupee has moved from a low of 63.50 to almost 72, 1M ATM vols have barely touched 7%. We have therefore not yet seen the kind of panic that one would typically associate with such a large move. That could have to do with the fact that fundamentally we are far better off now and we have accumulated significant reserves that can help us tide over such periods of stress.)


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