Indian currency notes of Rs 2,000, Rs 500 and Rs 200 denominations.
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The Indian rupee has been one of the most stable currencies in Asia-Pacific this year, but its stability is expected to be short-lived, according to UBS.
Strategists from the Swiss investment bank said in a note dated Aug. 25 that they expect the Indian currency to weaken to 77 per dollar by the end of the year — more than 5% weaker than current levels — and depreciate further to 79.5 by September 2022.
“We see the year-to-date INR stability as short-lived,” UBS said, adding that a retreat in U.S. bond yields lent stability to currencies like the rupee.
The rupee changed hands at around 72.98 per dollar on Friday, strengthening some 0.19% from January levels and appreciating from levels around 74.11 last month.
What kept the rupee resilient?
The rupee’s resilience has been primarily driven by two factors, according to Gaurang Somaiya, a foreign-exchange analyst at the Mumbai-based diversified financial services firm Motilal Oswal.
“First, consistent fund flows was positive for the rupee and second was the [Reserve Bank of India] bought dollars to build its reserves and prepare itself for any volatility,” he told CNBC.
Somaiya added that fund flows were not only led by the foreign institutional investors but also through a consistent stream of foreign direct investments.
FDI equity inflow into India grew 168% on-year to $17.57 billion between April and June — the first quarter in India’s fiscal year 2022. That refers to foreign money invested into Indian markets as well as businesses and is free of debt.
“Fund flows have been one of the major reasons that helped the rupee gain steadily,” Somaiya said. He pointed out that between August last year and now, the rupee has been stuck in a relatively broad range of 72 and 75 against the dollar.
That suggests the RBI has been “very active in managing the volatility of the rupee,” using its interventions to build up its foreign exchange reserves to near all-time highs, he said. Latest data showed the RBI had about $616.9 billion in foreign exchange reserves as on Aug. 20.
Somaiya said he expects the rupee to appreciate in the near term, following sharp gains in the domestic stock market. He predicted the currency could appreciate to levels near 72.20 against the dollar by the end of the year. In 2022, he expects the rupee to trade around the 73.50 to 74 level as the U.S. currency strengthens.
Current account situation
Last year, India recorded a current account surplus for the first time in over a decade due to a collapse in domestic demand for imports as a result of the pandemic. That implied the value of incoming goods, services and investments into India was lower than the amount that left the country.
In the first three months of this year, India’s current account deficit widened to $8.1 billion, or 1% of GDP, as the economy slowly recovered.
UBS strategists said India’s quarterly current account balance has deteriorated rapidly from last year, driven by a rebound in oil prices.
“Given our expectations for India’s current account deficit to persist in a 1-1.5% range into 2022, we expect the [rupee] to come under pressure when US yields start to rebound toward 2% by year-end,” they said.
Rupee can hold up ‘relatively well’
British investment bank HSBC has a more positive view on the Indian currency. It expects the rupee to reach 73 against the dollar by year-end and says the currency will likely end flat with its end-2020 level. In the longer term, the bank expects modest weakness where the rupee could weaken to 75 against the dollar.
HSBC expects the rupee to hold up “relatively well” in a stronger dollar environment as persistent FDI inflows and better foreign-exchange reserves will help the currency withstand external headwinds, Madan Reddy, Asia foreign-exchange strategist at HSBC Global Research, told CNBC.
“The uncertainty around slowing sequential global growth and the Fed’s policy normalisation should therefore leave the [rupee] as an outperformer in Asia,” he said.
U.S. Federal Reserve chair Jerome Powell last month indicated that the central bank is likely to begin withdrawing some of its easy-money policies before the end of the year, though he still sees interest rate hikes off in the distance.
Reddy said the likelihood of tighter monetary conditions in the U.S. and a re-widening of India’s current account deficit point to a higher dollar/rupee pair. But, he added, excessive weakness in the rupee is less likely as the RBI would eventually remove excess liquidity conditions from the economy and restrain inflation expectations.
He pointed out the central bank’s foreign-exchange purchases in recent years have helped suppress longer-term depreciation expectations among local traders.
“In our view, the RBI’s FX policy will continue to remain a key driver of rupee’s performance,” Reddy said, adding that he sees little incentive for the central bank to tolerate the rupee’s strength as long as capital inflows are not broad-based.
“For now, the RBI seems to be comfortable with [dollar/rupee] oscillating within its year-to-date trading range of 72.5-75.5,” he said.
Motilal Oswal’s Somaiya added that domestic factors like growth recovery are more in favor of a stronger rupee, but global factors could cap gains against the dollar.