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'Factors that are driving a structural re-rating of the Rupee'

Monday, March 20, 2017
By Anindya Banerjee

Anindya Banerjee Currency Derivatives Researcher, Kotak Securities

What a week it was for the Rupee bulls. The currency zoomed against the US Dollar and well past its peers to clock a gain of 2%. Since the early part of the year I have been warning that a weak US Dollar is coming. Much of it due to Trump’s administration effort to score economic gains from a weak currency. However, the strength in the Rupee since the end of 2016, in which it rallied by 4.14% against USD, is mostly due to internal factors. In this piece I will focus on factors that are driving a structural re-rating of the Rupee.

There are multiple frameworks to explain as well as forecast the value and direction of the real value of a fiat currency. They are termed as international parity conditions. However, none of them work all the time. If they did, then students of economics would concur, that making money out of currency trading would become a forgone conclusion. At the same time, it must be acknowledged that understanding these relationships and various other currency models, would help us create a framework which can offer, at least qualitatively, the factors that can drive the real value of a currency.

I will talk about three major factors to understand the structural strength or weakness in the real value of the currency. Remember, when we refer to real value, we strip out the effect of inflation from the argument. However, generally speaking, the direction in the nominal value of a currency pair would not be much different from the real value of the currency pair, in this case USDINR.

For most of us, we are so hooked onto the value of USDINR that we miss the larger strength and weakness of Rupee through the lens of other currencies. How well Rupee is doing needs to be judged from a broad scope, than from a narrow one like USDINR. There has been a sea change in the way behaved before September 2013 and how it fared afterwards. That is the month, when Dr. Rajan took over as the Governor of the RBI. The two critical factors that brought about the change in performance of Rupee were the change in thinking at the RBI at how it manages the value of Rupee and the political change that happened at the center.

The three factors are:
Real interest rates
Risk premium
Perception about the long run competitiveness of the nation

1. Real interest rates:
Higher the high real rates for a nation, the more attractive the currency to foreign investors. Real interest comprise nominal interest and inflation. Markets are driven by current as well as future expected direction of nominal interest rate and inflation of a country. In India, since the days, Dr. Rajan became the governor, RBI has ensured that real rates on Rupee stay positive. That has helped the currency remain strong at a time when EM currencies have been battered by weak growth, rising rates in US and exceptionally strong US Dollar overseas. Inflation expectation has come off in India, as both RBI as well a government walked the talk on enacting policies that promotes low inflation in the country. Higher the inflation expectation, the more cagey foreign investors investing in a country, as higher inflation corrodes the value of a currency. Hence, by keeping monetary policy neutral and inflation expectation low, Indian Rupee has remained strong and stable.

2. Risk Premium:
Indian policymakers are encouraging an economic environment that promotes price stability and long-run growth. At the same time a robust political environment allows for bold economic reforms. The recently concluded state elections have significantly boosted the political capital of the Namo Govt. These are encouraging signs as India, after a long time, is being run by a leader who wants to push ahead with changes that can significantly boost long term growth for the nation. India boasts of a stable financial system.

3. Perception about the long run competitiveness of the nation:
Long run competitiveness of a nation can be improved by improving the social capital and political capital of a country. From economics 101, we understand that a country can develop or achieve higher growth per capita or person is by increasing capital stock per person and also fostering innovation and risk taking. However, in order to absorb physical capital efficiently and also promote a culture of innovation and risk taking there is a need of high “social capital”.

India still has a way to go to strengthen property rights and simplify tax laws and commercial laws to ease doing of business in the country. However, the political establishment remains committed, to make it easier for businesses to come up, prosper and wind up.

Going forward, we believe Indian Rupee would continue to gain further against US Dollar. With global trend of the US Dollar remaining mixed, there is scope for Indian Rupee to strengthen towards 64.60/80 levels on spot against US Dollar.

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