Recent INR depreciation has been very sharp. The INR depreciated to a low of INR 74.39 a decline of more than 14% since the start of the year. Through this article, I intend to cover a few parameters to consider while analyzing possible INR movement and our views in the current market environment.

Few parameters to consider while evaluating INR

1. The balance of Payments – it comprises two parts capital account (foreign direct investment i.e. FDI and foreign portfolio investments i.e. FPI) and current account balance (total exports-imports). In India, the current account is mostly in deficit as we import more than we export. Thus, importers need more USD than exporters need INR. India’s capital account largely funds the gap between the USD and the INR demand.

• This year India’s current account deficit (CAD) has increased to 2.4% of GDP, a 4-year high. Crude prices make the largest portion of our imports. Hence, a more than a 25% rise in crude oil prices has led to a wider current account deficit.
• Additionally, while FDI has been strong this year as well, net FPI has been negative. FPIs have sold about INR 92,000 crores worth of Indian equities and bonds compared to net buying of about INR 194,000 crores last year.

2. USD strength – Global strength in the USD would mean a depreciation of the INR against the USD. This year the USD has appreciated by more than 4% against a basket of global currencies. Two factors have led to USD strength this year.

• Strong US economic growth which leads to an increased demand for US assets.
• Capital outflow from emerging markets (EM) amid tighter monetary policy in the US which leads to a rise in borrowing cost and hence reduced risk appetite to invest in EM assets.

3. Weakness in EM currencies – While EM currency weakness is largely due to USD strength, this year we saw specific problems in a few EM countries.

• Turkey Lira and Argentinian Peso depreciated more than 40% this year as capital outflow amid elevated current account deficit weighed on these currencies. Contagion effect of this was seen across other EM currencies as well.
• Weakness in Chinese Yuan – Chinese Yuan has the largest weight in the EM currency basket, hence negative sentiments towards Chines Yuan impact most EM currencies negatively. This year Chinese Yuan has declined by about 6% amid US-China trade tension.

4. Inflation differential– Theoretically currencies depreciate proportional to the difference in inflation between the two countries (relative purchasing power parity). i.e. Over a long period, the INR should depreciate by about 3%-4% annually against the USD as historically inflation in India has averaged about 5%-6% and the US is about 2%. However, post-2013 (when INR touched 69 against the USD) the INR appreciated for 5 years, suggesting that the INR had some catch up to do with respect to the USD.
5. FX Reserves – This is the foreign money held by central banks so that It can pay back its liabilities. The RBI can use its FX reserves to intervene (buy/sell USD) in the FX market to control significant INR volatility. India’s FX reserves reached an all-time high of USD  426bn, which is enough to cover 9 months’ worth of imports and 4 times of short-term external debt. In 2013, when INR had seen a similar level of depreciation, India’s FX reserves could cover only 6 months’ worth of imports and were 3 times short-term external debt. In 1991 when India had to devalue its currency due to the financial crisis, India did not have enough FX reserves to cover for short-term external debt and could cover only 3 weeks’ worth of imports. India had to ship physical gold to raise money.

Our views on the INR.

We believe long-term fundamentals are still supportive. India has enough FX reserves, which the RBI could use amid elevated INR volatility. The government has announced few measures to curb widening current account deficit, further such measures can be expected. Weakness in EM currencies and USD strength is probably overdone.

However, short-term risks to INR prevail. The risk to crude oil prices remains as US sanctions on Iran come to effect in November. While some bit of the supply cut is likely already priced in, the extent of supply cut is still uncertain. Secondly, the risk of further escalation of US-China trade tensions also remains.

In the long run, INR should depreciate by about 3-4% against the USD. However, recent INR depreciation has been sharp. Short-term risks prevail but long-term fundamentals are supportive. We believe, most of the INR weakness is behind us and INR should remain around current levels, short-term risks notwithstanding.