The Pound-to-Indian Rupee Pre-Xmas Update and Outlook for Year Ahead

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The Pound-to-Rupee is moving sideways within a broader medium-term uptrend. With risks weighing on both currencies in 2018, the outlook for GBP/INR is opaque.

Since September the Pound-to-Indian-Rupee has pretty much oscillated in a range between 84.80 and 88.00, and we have to shift over to the weekly chart to see anything resembling a trend.

Daily chart showing extended sideways market action

The weekly chart (below) shows a gentle incline since the post-referendum lows of 78.81 plumbed in October 2016. Previous to that, the trend was down overall since the 2013 highs of 100 Rupees to the Pound.

Weekly chart showing extended sideways market action

The rise in the Rupee between 2013-2016 was based as much on Indian growth as it was Brexit politics because it was during that time that it overtook China as the fastest growing major economy in the world, a position it still retains.

The turnaround in fortunes since 2016 has mirrored the Pound's story against most of its other partners because, in the case of the Rupee, there has also been a deterioration in the outlook over the same period.

Concerns are focused on a handful of issues that could create headwinds for the currency going forward.

These include the Rupee's reliance on foreign direct investment and portfolio flows, the rising price of oil, the slowing down of the domestic economy, a weak banking sector and limited scope for further stimulus due to budget constraints.

Taken together these have reigned in forecasts for the Rupee when they had previously been quite optimistic.

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Reliance on Foreign Inflows

The main issue confronting the Rupee is its reliance on demand from foreign investors to maintain its current levels.

Foreign capital inflows have risen stratospherically since India's growth boomed after 2013, with international investors competing to seek a 'piece of the action' either via purchasing shares in Indian companies, buying hard assets or lending money to the government or corporations through the purchase of bonds.

"In Q1, net portfolio investment was USD12.5bn, compared to USD2.1bn last year," says Sue Trinh, RBC Capital Markets’ Head of Asia FX Strategy (our brackets).

"These flows are vulnerable to a reduction in global liquidity/turn in global risk sentiment and investment limits – foreign investors have used up almost all of their eligible quotas to buy Indian bonds."

A major contributor to foreign inflows has been money for the purchase of Indian shares, given the strong uptrend in Indian stocks that has seen the Indian BSE Sensex Stock Index rise over 22% in 2017 alone.

Yet according to research from Singapore Based bank DBS Group, there is an increasing disconnect between the rising Indian stock market and the more modest trajectory of real domestic growth, which is at risk of resulting in a major stock market correction in 2018.

"The divergence between a soft real economy and buoyant financial markets may not persist in 2018/19; the economy could bottom out on the heels of a strong global economy, or markets could turn impatient if growth remains muted," says Radikha Rao, an economist at DBS.

As noted, the resolution may not necessarily be a pull-back in the stock market but could be another strong rise in domestic growth.

Indeed, it could be argued that the recent muted growth rate is more to do with growing pains, after the government's raft of economic reforms, rather than inherent weakness.

The government introduced a radical demonetization programme in late 2016, which phased out the use of high denomination notes in order to encourage people to open bank accounts, but a byproduct of the reform was a temporary stutter in consumption. The imposition of a universal sales tax also weighed on growth.

The slowdown caused by these reforms may only a temporary growing pain. The government's most recent reform is to pump money into the banking system to help clear the high number of non-performing loans and encourage banks to start lending more liberally - an altogether more growth-friendly strategy entirely.

Indeed, due to the reforms, credit rating agency Moody's actually gave India an upgrade to Baa2 so, whilst they may have caused short-term headwinds, the reforms have had positive effects too.

Price of Oil

Oil constitutes a third of Indian imports so it is quite a major determinant of the trade balance and whether the country has to import more than it exports.

Higher oil prices can impact on the trade balance quite rapidly and it is estimated that a 10% rise would increase India's current account deficit by 0.4%.

Whilst oil prices remained fairly anchored around $50 per barrel throughout most of 2017, they have also rallied more recently following an OPEC-led decision to extend a self-limit on oil supply that was imposed back in 2016.

Clearly, if the restraint of oil supply continues to force the price up in 2018, it will cost India more and more to meet its energy requirements.

From an FX perspective, the immediate impact of this would be an increase in Rupee-selling simply to purchase the more expensive oil imports, which would weaken the currency.

The second-round effects could also impact negatively on the Rupee. These include the risk of a rise in inflation from the double whammy of more expensive fuel and a weaker currency making all imports more expensive. The latter could also impact on real growth by crimping wage buying power. Real growth is total GDP growth minus inflation.

A more widespread economic slowdown could then follow, which would lead the economy and the currency into a vicious and self-reinforcing cycle.

However, we are far away from that point and a major offsetting factor in the forecast for oil prices is the influence of an increasing supply of shale oil in the US. This could act as a counterweight and help keep oil prices locked down in a range between $50-60 per barrel.

Stimulus Ceiling

Most analysts see India's ability to artificially stimulate growth, either by handouts from the government or through central bank stimulus (lower interest rates) as being hampered in 2018 and this has also depressed the outlook for the Rupee (INR).

The government will struggle to give away more money now that it has spent so much already on recapitalising the banks. To be more generous would also contradict its promise to reduce the budget deficit.

The government has been quite successful in reducing the budget shortfall from the -6.1% it stood at in 2013 to the most recent -3.5% figure for the forward year 2017, but falling tax revenues are making it more difficult for India to balance the books, and means extra money to drive growth will probably not be forthcoming.

India's debt, at 76% of GDP, is not small so it can ill afford to continue borrowing more than it spends.
From a monetary policy perspective, inflation is at risk of rising, which will make it very difficult for the Reserve Bank of India (RBI) to cut interest rates in order to stimulate growth.

Normally, higher interest rates mean a corresponding rise in the currency as they attract more inflows of foreign capital that is seeking to exploit higher returns. The pressure not to cut rates provide some support to the INR.

In their 2018 forecast for the currency, ING Group predicts the RBI will leave policy unchanged, with a neutral outcome for the Rupee.

"We think the RBI will remain cautious on inflation as global oil price edges higher, while a weak INR and fiscal slippages complicate policymaking. We forecast on-hold RBI policy through 2018 and a 64-66 USD/INR trading range for 2018."

DBS's Radikha Rao shares ING's neutral outlook for RBI policy, albeit with a slight bias to a risk of higher rates.

She says a further disincentive to the RBI cutting rates will come from the general global trend toward higher interest rates, in particular in the US, which will support the Dollar.

Through fear of creating too much volatility in the Rupee-Dollar exchange rate in particular, Indian rate setters will probably refrain from cutting.

"In fact, rate hikes may be necessary in late FY19 if growth surprises on the upside and pushes inflation above its 4% target," adds Rao.

Get up to 5% more foreign exchange by using a specialist provider by getting closer to the real market rate and avoid the gaping spreads charged by your bank for international payments. Learn more here.