Indian Rupee: an interplay of strong domestic macros and dangerously lopsided global forces
Rupee continues to outperform its peers, barring the one day snap decline that happened last week on account of military operation conducted by Indian armed forces against terror camps in PoK. Indian currency is an interplay of domestic and global macro and micro forces. Domestic script would continue to remain supportive for Rupee as reforms and better policies improve long term growth potential. Current account is in near balance, inflation remains low, public investment is being better targeted and efforts are being made to increase the size of the official economy over the black economy. The next big challenge in front of policy makers is the rollout of Goods and Services Tax, scheduled for next calendar year. It is one of the biggest reform initiative undertaken in post-Independence era and if done properly, it can not only reduce cost of doing business but also augment government revenues. However, there will be losers, as there is always with any reform, in this case the players in the unorganized sector who were surviving on tax arbitrage. Apart from the tax reform the next big challenge for the government is creation of well-paying jobs in the economy. Construction sector and real estate sector is going through a cyclical downturn and the sector employs large number of semi-skilled and unskilled workers. India’s manufacturing sector is not in a position to absorb those people displaced from the real estate sector. It is always hard to predict how long the downturn in real estate can last. We have been bearish on real estate since 2013, as a part of a broad bearish theme on hard assets, viz., real estate and commodities. Cycles in real estate, even in a country like India, has been between 6-10 years, both upswings and downswings. There is another force that Indian job market has to adapt to is the rising automation and digitization. The impact of them are not only being felt by employees in manufacturing sector but also in services sector as well. Therefore going forward the employment intensity of national output would continue to decline as more output is generated using less labour.
Though Indian Rupee would continue to outperform its peers but its value against US Dollar is always a function of global headwinds and tailwinds. Global economy continues to weaken and so is global trade. The World trade Organization cut its forecast for global trade growth this year by more than a third on Tuesday, reflecting a slowdown in China and falling levels of imports into the United States. The new figure of 1.7 percent, down from the WTO’s previous estimate of 2.8 percent in April. This will be the first time in 15 years, the WTO says, that the ratio between trade growth and world gross domestic product (GDP) has fallen below 1:1; it will be around 1:0.8. Several wild cards could spook the outlook, the WTO says. Monetary policy changes in developed countries could lead to financial volatility, for one. The Brexit vote in the United Kingdom, it notes, has also increased uncertainty about future trading arrangements in Europe. And there’s the growing trend towards protectionism across the globe.
The global economic rebalancing started since 2007-08, something which I have explained in detail in my previous write-ups. Since then monetary authorities have enacted one after another radical monetary policy step to smoothen the economic and financial impact of this rebalancing. However, time is now running out for these folks. Central bankers have used the cost of money, first the short term and then the long term and finally the risk premia, to push asset prices higher. They believe that higher asset prices would alleviate much of the pain of global economic adjustment as wealth effect would keep consumers happy and help leveraged corporates delever in a painless manner. What they did not account for was the concentration of financial wealth, mainly stocks, in the hands of the few. Result, has been growing wealth of the few and rising inequality. This process may have played a part in the rising wave of anti-establishment sentiment across the developed world. It can be termed as the political cost central bank’s extraordinary monetary policies.
There remains a financial cost of these easy money polices as well. The cost is the burden on the financial sector. Central banks first lowered rates to zero for money lend for shorter maturity. Then they used long term bond purchase program to push the cost of money lower for longer maturities. At the same time developed market central banks vowed to keep rates at zero bound or low for an indefinite period of time. The result has been steady decline in long term rates in the economy. The reason the central banks have been forced to lower their outlook on interest rates over the long term because the long term outlook on growth and inflation has been marked steadily lower. It is not just the central banks, but market participants as well have pushed yields on long term money to below zero, signaling that they do not expect much of economic growth and inflation to surface even over a longer horizon. Yield curve has become flatter and below negative for rates upto 10-15 years. Financial institutions are unable to pass on the burden of negative rates to depositors and their loan products are priced of the government yield curve. As a result, financial institutions in Europe and Japan have seen their earnings power erode. A weaker earnings power after years of financial crises is bound to make these institutions dangerously weak. This has got the central banks concerned. As a result, there is now talk of yield curve control viz. to make the long term yields positive and the curve upward sloping. But that is easier said than done. In absence of long term growth and inflation expectation, rise in long term yields is dependent on either central banks tightening money supply by selling long term bonds from their portfolio or quickly raising short term rates. Central banks are reluctant to make that move as it would pull the rug under the global stock market, real estate market as well corporate credit market. A downturn in financial asset prices can risk pushing the global economy into a full blown recession. Therefore, central banks in the developed world as caught in a dilemma. If they continue to support asset prices it may come at the cost of stability and health of the financial sector viz. Banks & lenders, insurance companies and pension funds.
Before I sign off let me touch upon outlook for Rupee over the near term. RBI monetary rates are an interplay of retail level inflation and state of slack in the economy. In its last monetary policy, RBI had sounded cautious in its outlook on inflation as disinflationary impact of a good monsoon was not yet fully known. However, since last monetary policy in August, trend of retail inflation has surprised on the downside. CPI for August came in at 5% from a 22-month high reading of 6.1% in July. Expectation of bumper kharif harvest is causing prices of cereals and pulses to decline. We expect the food and fuel inflation to have a dampening effect on the headline for rest of FY17. As a result, the headline inflation may drop further towards 4.00/4.2%, as high base of last year also plays out. From inflation as we shift our focus to growth. Industrial production fell 2.4%YoY in July with deceleration across manufacturing, mining and electricity. From the demand side, capital goods production fell ~30%YoY, a 9th straight month of contraction. Weak growth and low inflation has opened up the possibility for reduction in interest rates in October, by 25 bps. A possible rate cut can have positive impact on India’s bond prices, where we continue to remain bullish, with new 6.97% GOIsec 10 year expected to hit 6.68/6.70% over the near term. Indian Rupee is expected to strengthen if RBI lowers rates, towards 66.25/30 levels on spot from 66.63 currently. However, RBI intervention would prevent any sharp appreciation of the Rupee.