Reviewing the Indian rupee's performance

The Indian rupee (INR) is currently experiencing conflicting undercurrents. On the positive side, the INR is being pushed higher by capital inflows, partly due to India's strong growth rate, but also due to speculation that there may be an imminent FX regime adjustment in China. Such an adjustment may in turn impact the Indian economy. On the negative side, the Indian trade deficit is at record levels - on a monthly basis - and export prospects look less encouraging given the projected slowdown in global growth. As a result, the INR is looking increasingly overvalued from a medium- to long-term fundamental perspective.

However, in our view, positive cyclical fundamentals may push the INR even stronger in the near term. Investors continue to look favourably it would seem on Indian economic fundamentals and as a result invest in Indian local markets. Indeed, for at least the last 6 months, there has been a marked and distinct change in how global investors have viewed India. As a result, we may be seeing a structural rather than cyclical shift in capital inflows, although it is probably too early to say. Certainly, government economic policy has done much to encourage such a shift though significant fiscal and infrastructure challenges remain.

Despite such positives, there are important obstacles to further, significant INR appreciation from current levels in the next 6 months. Firstly, the trade balance continues to deteriorate. In line with this, as noted above, the INR is becoming increasingly over-valued. As a result, we think it highly unlikely that the Reserve Bank of India (RBI) will tolerate further significant losses in INR competitiveness for long. For these reasons, we have adjusted our USD-INR forecasts accordingly (old forecasts in brackets):

•End-Q2 43.30 (43.70)
•End-Q3 43.70 (43.90)
•End-Q4 43.90 (43.50)
2006:
•End-Q1 44.00 (44.00)

CNY Revaluation May Boost the INR

USD-CNY non-deliverable forward (NDF) correlations with USD-INR, USD-HKD forwards (at least until the recent fine-tuning of the currency board) and USD-JPY have consistently been amongst the highest among other currency pairs. Renewed news flow regarding a potential Chinese Yuan (CNY) regime change since the 29 th of April and consequent move in the USD-CNY 1-year NDF below 7.8 saw the INR rise 1% against the USD to 43.3/USD. Subsequently, the INR retreated back to 43.64/USD as speculation regarding the CNY regime receded. The INR's increasing sensitivity to offshore developments, particularly those in China and elsewhere in the broad Asian region, is clearly an indication of growing integration with the region as a whole. Clients should note that the Asia-Pacific region - excluding Japan - contributed more than 20% of India's export earnings in 2004. Meanwhile, India-China trade in 2004 exceeded USD10bln. This compares with only USD580mln in 1994/95. Trade with Malaysia too has shown notable increases (2% of India's trade).

For China, our base case still assumes that the authorities will adjust the USD-CNY band to +/-3%. In line with this, we also look for a change in Malaysia's FX regime, whereby the Malaysian authorities de-peg USD-MYR and move to a NEER-based managed float regime. As a result, we think these two important developments should give the USD another push lower, particularly but not exclusively against Asian currencies. Note that at the meeting of Asian central bankers in Seoul, there appeared to acknowledgement that further Asian exchange rate flexibility was needed in order to adjust global economic imbalances - although it was stressed that exchange rates alone could not do the job; that policy adjustment in the U.S. in particular was also needed. In turn, the INR may see further volatility near term and at least has the potential to appreciate towards the 43.00 levels given these factors. The extent of any INR move will of course be contingent to a large degree on the adjustment in other Asian currencies. An important difference between the INR and many other regional currencies (for example KRW, TWD, SGD) is that it does not enjoy a strong trade surplus. On the contrary, the Indian trade balance is in deficit and this deficit is reaching record highs. We thus expect any gains in the INR to be short-lived.

Loss of INR competitiveness is a Longer-Term Concern

The RBI uses the Real Effective Exchange Rate (REER) to assess the INR's competitiveness. Based on the Standard Chartered INR REER index, which essentially replicates the RBI's 5- country REER (base year 1993-94), the INR's real value has rarely been outside a 3.5-4.0% band. However, it is currently roughly 7% overvalued in comparison with its equilibrium value of 100 (1993-94 parity). An overtly overvalued currency over a sustained period of time will impact India's trade competitiveness. This is because an overvalued currency makes imports cheaper and exports more expensive and thus exacerbates trade imbalances and hurts growth. Thus, the central bank in such a situation can either intervene in the foreign exchange markets and correct the imbalances or alternatively allow market forces to do so.

RBI focus is on Inflation Management

This year the REER has stayed close to the steep end of its observed range. The RBI's tolerance for an overvalued rupee has partially to do with its desire to maintain a balance between inflation and growth with the balance of risks having shifted to equal emphasis on growth and inflation in our assessment. An overvalued currency in an environment of high imported prices, can moderate inflationary pressures and this we see as a key reason why the INR remains overvalued near term. Once the inflation rate retreads back to more tolerable levels, the overvaluation concerns would once again get back into focus.

Record Trade Deficits

In 2004/05 India recorded its largest ever-annual trade deficit of -USD26.5bln due to high oil and goods imports. Even the trade gap excluding oil imports has been negative since mid-2004. This high deficit was despite a healthy 25% growth in exports. More recently the monthly trade deficit in April 2005 was a record -USD3.85bln, the largest monthly deficit in India's history. The current account has also deteriorated switching from a record high surplus of USD8.1bln in 2003/04 into deficit. In the first 9 months of 2004/05 the deficit stood at -USD7.4bln. We expect the current account to remain in deficit (-1.0% of GDP) in 2004/05 and (-0.8%) in 2005/06.

US, China Slowdown May Cause Further Deterioration

Given the expected slowdown in global growth, especially in the US and China (two of India's largest trade partners), India's export growth is likely to decelerate to 15% in 2005/06 from 25% in 2004/05. The recent comments by the Finance Minister hint at growing concerns regarding the rising trade deficit - "we need to see that the trade deficit doesn't become an albatross around India's neck".

Capital Inflows Expected to Remain Strong

Recent overseas equity issues and the pipeline of issues for some Indian companies, together with awaited external commercial borrowing proceeds should keep capital inflows steady through 2005. Recent affirmative policy measures by the government such as relaxation of foreign investment limits in construction and telecommunications sectors, together with prospects of further relaxation in controls in other sectors such as mining, signal improving prospects for FDI. To a considerable extent this will limit sharp INR depreciation. Given concerns on inflation, we now expect the RBI to hike the reverse repo rate once again at the quarterly meeting in July.

As a result, we revise our INR forecasts to 43.3 by end-June 2005 with a 30% probability that it could touch 42.9. However, we then see a gradual depreciation of the INR and retain our March 2006 INR forecast of 44.0/USD. The downside risks are however, limited by the expected strong capital inflows.

FX Strategy
Callum Henderson
+65 6530 3282
David Mann
+44 20 7280 6851
Eric Chong
+65 6530 3617
Marios Maratheftis
+44 20 7280 6214
Economics
Shuchita Mehta
+9122 2267 6400