INR: Short-term pain, long-term gain

INR stuck in a slowly depreciating range

The INR has recently been range bound between 46.00- 46.50 with the market buying on dips and the central bank protecting the top end of the band. Three factors dominate the outlook for the INR.

First, net inflows have reduced significantly. Second, internationally, the dollar has stagnated. Third, inflation is largely imported and has therefore given rise to expectations that the central bank will not allow the currency to depreciate significantly.

Of these, the future direction of the dollar is the most significant. Our core projection still foresees Asian currency strength and INR appreciation. However, this view is contingent upon oil prices receding convincingly to sub-USD40 per barrel levels. Pending this, the risk is that the INR will slowly depreciate in line with inflation differentials.

Flows are very finely balanced

The soaring oil import bill has hurt the current account. We estimate the oil import bill at USD26bn for FY 2005.

The good news is that excluding oil payments, the trade balance is still in surplus. IT exports are also helping to contain the damage to the external accounts. However, thanks to tightening global liquidity and domestic policy uncertainty, portfolio capital inflows have dried up.

The biggest negative is market positioning. Persistent short-term capital outflows are plaguing the market as the corporate sector is in the process of adjusting to a more balanced exchange rate outlook. Overall, the flow picture is very finely balanced and incessant reserve build up is clearly a thing of the past.

The USD correction against the majors is close to its end. The "broadening" of the dollar weakness cycle is the likely way forward. Asian central banks no longer seem comfortable with currency strength in the view of oil related growth concerns. The next round of INR appreciation will likely begin once the dollar/Asia correction starts.

Imported inflation has helped the currency

So far the Reserve Bank has not let the exchange rate appreciate, in real effective terms, to control inflation.

The government has responded to the situation by pruning custom duties on petroleum and steel products. This move is targeted specifically at the commodities responsible for the surge in inflation.

Currency appreciation would have achieved similar results but would have had wide-ranging competitiveness implications. That said, tightening via the exchange rate route remains an option should the situation get out of control. This fact has tempered the market's bearish view on the INR.

Longer-term, the INR should still appreciate based on our view of Asian currency strength.

Nearer term, a direction-less dollar, a soaring oil import bill, market positioning, and positive inflation differentials will weigh on the INR. Therefore, until USD weakness resumes, the currency should trade with the range, depreciating by about 0.25% every month.

Over the 6 -12 month horizon, falling oil prices, Asian currency strength, and a greater balance in corporate sector exchange rate views should help the currency to gain to 44.50 per USD.