Reviewing the Indian rupee's performance (page 1 of 2)

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.