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Rajeev Malik +65 64167890 rajeev.malik@clsa.com 29March 2012 ECONOMICS RESEARCH Rupee wo es INR remains one of the riskiest currencies. India’s large and widening curre nt account (CA) deficit and its dependence on volatile capital inflows make it vulnerable to becoming a casualty of swings in global risk appetite and crude oil prices . INR’ s recove ry in January was due p artly to RBI’ s aggres sive currency intervention, although g lobal risk-o n, RBI’ s anti- spec ulat ive me asur es and de reg ulati on of NRI de posi t rate s also helped.However, INR has been weakening against USD since early February, despite a surge in portfolio inflows into India (1Q12: around USD13.5bn). Global risk-on will likely boost volatile capital inflows unless domestic factors, such politics and policy coordination, are turn-offs. But capital inflows may not be ade quate to elimina te concer ns about smooth financing of the CA deficit. On our forecast, the CA d eficit of 3.9% of GDP in FY13 is beyond the RBI’s comfort level. This, along with our expectation s of a stronger dollar , sets the stage for INR to weaken. We maintain our end-2012 forecast of INR55:USD. INR has had an excep tional ly volat ile ride (Figur e 1). It slumped to nearly INR54:USD in mid-December before recovering to INR49:USD by mid- February due to a combination of an unexpectedly strong jump in portfolio inflows triggered by global risk-on and RBI’ s desperate measu res, including aggressive currency intervention in January. However, it weakened subs equen tly and h as broken above t he 51-mark des pite US D weakn ess. The  pace of capital inflows has slowed recently even as the CA deficit remains large. In the absence of meaningful RBI currency defence, INR had to weaken. Figure 1: ADXY Index and INR/ USD Note: Rise in ADXY indicates appreciation. Source: Bloomberg, CLSA Asia-Pacific Markets 35 37 39 41 43 45 47 49 51 53 55 100 10 5 11 0 115 120 12 5 Jan 08 Jan 09 Jan 10 Jan 11 Ja n 12 (Index)  A D X Y Inde x INR/USD (RHS) (INR/USD, reverse axis) INR REMAINS VULNERABLE EXCEPTIONALLY VOLATILE RIDE FOR INR  YTD INR HAS DEPRECIATED MORE THAN ADXY
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Rajeev Malik  +65 64167890 [email protected] 29 March 2012

ECONOMICS RESEARCH

RupeewoesINR remains one of the riskiest currencies. India’s large and widening

current account (CA) deficit and its dependence on volatile capital inflows

make it vulnerable to becoming a casualty of swings in global risk appetite

and crude oil prices. INR’s recovery in January was due partly to RBI’s

aggressive currency intervention, although global risk-on, RBI’s anti-

speculative measures and deregulation of NRI deposit rates also

helped. However, INR has been weakening against USD since early

February, despite a surge in portfolio inflows into India (1Q12: around

USD13.5bn). Global risk-on will likely boost volatile capital inflows unless

domestic factors, such politics and policy coordination, are turn-offs. But

capital inflows may not be adequate to eliminate concerns about smooth

financing of the CA deficit. On our forecast, the CA deficit of 3.9% of GDP

in FY13 is beyond the RBI’s comfort level. This, along with our

expectations of a stronger dollar, sets the stage for INR to weaken. We

maintain our end-2012 forecast of INR55:USD.

INR has had an exceptionally volatile ride (Figure 1). It slumped to nearly

INR54:USD in mid-December before recovering to INR49:USD by mid-

February due to a combination of an unexpectedly strong jump in portfolio

inflows triggered by global risk-on and RBI’s desperate measures, including

aggressive currency intervention in January. However, it weakened

subsequently and has broken above the 51-mark despite USD weakness. The

 pace of capital inflows has slowed recently even as the CA deficit remains

large. In the absence of meaningful RBI currency defence, INR had to weaken.

Figure 1: ADXY Index and INR/USD

Note: Rise in ADXY indicates appreciation. Source: Bloomberg, CLSA Asia-Pacific Markets

35

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49

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55100

105

110

115

120

125

Jan 08 Jan 09 Jan 10 Jan 11 Jan 12

(Index)

 ADXY Index

INR/USD (RHS)

(INR/USD, reverse axis)

INR REMAINS VULNERABLE

EXCEPTIONALLY VOLATILE

RIDE FOR INR

 YTD INR HAS DEPRECIATED

MORE THAN ADXY

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India unplugged29 March 2012

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INR’s performance in recent months has been similar to that of some of the

risky EM currencies (Figure 2). This suggests an understandable strong global

risk on/off dimension that is complemented by domestic factors. For example,

the turning point for INR in December is not substantially different from that of 

other EM currencies, despite the RBI’s anti-speculative actions and

deregulation of NRI deposit rates.

Figure 2: Emerging markets exchange rate

Source: Bloomberg, CLSA Asia-Pacific Markets

Looking ahead, three key factors will affect the outlook for INR. First,

sustainability of global risk-on and its impact on international crude oil prices

and capital inflows into India. Higher crude oil prices widen the CA deficit but

higher capital inflows due to global risk-on temporarily ease the financing

 pressure. Every USD10/bbl increase in crude oil adds around USD10bn (0.5%

of GDP) to the CA deficit. As highlighted in Figure 3, we expect the CA deficit

to widen to USD73.1bn or 3.9% of GDP in FY13 from an estimated

USD66.6bn (3.7% of GDP) in FY12.

Figure 3: Current account deficit

Note: FY12 and FY13 are CLSA forecasts; Source: CEIC, CLSA Asia-Pacific Markets

80

85

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100

105

110

115

120

125

130

Jan 10 Jul 10 Jan 11 Jul 11 Jan 12

Russia - RUB/USD

India - INR/USD

Brazil - BRL/USD

Turkey - TRY/USD

(Index, 1 Jan 2010 100)

(3)

(2)

(1)

0

1

2

3

4

5

(20)

(10)

0

10

20

30

40

50

60

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FY91 FY93 FY95 FY97 FY99 FY01 FY03 FY05 FY07 FY09 FY11 FY13

(% of GDP)(USD bn)

Current account deficit

Current account deficit % of GDP (RHS)

INR AT THE MERCY OF CRUDE

OIL PRICE AND CAPITAL

INFLOWS

INR BEHAVING SIMILAR TO

OTHER RISKY EM

CURRENCIES

CA DEFICIT TO WIDEN TO A

RECORD HIGH

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But no economy with a large CA deficit should rely mainly on portfolio

inflows to finance the deficit as these inflows can be uncertain. Also, it is

unlikely that capital inflows will comfortably and smoothly finance the wider 

CA deficit in FY13.

Second, outlook for USD. We expect USD to strengthen in 2H12, which in turn

should be negative for INR. Note that INR has weakened in recent weeks

despite USD weakness (Figure 4). Such an outcome does not boost confidence.

Figure 4: INR/USD and DXY index

Source: Bloomberg, CLSA Asia-Pacific Markets

Third, RBI’s intervention in the currency market to support INR, if capital

inflows are inadequate to finance the CA deficit. Currency intervention to

 prevent depreciation of the exchange rate is a losing proposition that will leave

the central bank with a combination of a decline in its foreign reserves and a

still-weak currency, and could also be an invitation for a speculative attack.

Figure 5: RBI’s currency intervention and INR/USD

Note: Positive number means net purchase of USD; Source: Bloomberg, CEIC, CLSA Asia-Pacific Markets

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49

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5565

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Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12

(Index)DXY Index

INR/USD (RHS)

(INR/USD, reverse axis)

38

40

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50

52

54(20)

(15)

(10)

(5)

0

5

10

15

Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12

(USD bn)

RBI's net sale/purchase of USDINR/USD (RHS)

(INR/USD, reverse axis)

INR HAS DEPRECIATED

RECENTLY DESPITE USD

WEAKNESS

STRONGER USD WILL BE

NEGATIVE FOR INR

RBI UNLIKELY TO INTERVENE

AGGRESSIVELY

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RBI has been aggressive in supporting INR with heavy USD selling at

USD7.3bn in January, only slightly lower than the currency intervention of 

USD7.8bn in December (Figure 5). However, looking ahead, RBI is unlikely to

 prevent INR from adjusting because of inadequate capital inflows, although it

is likely to manage INR better than it did late last year.

The combination of above three factors suggests to us that INR is poised to

weaken. We reiterate our end-2012 forecast of INR55:USD but the ride will be

volatile due to shifting global risk appetite.

Figure 6: Net FII – Debt and Equity

Note: March 2012 data up to 28 March; Source: CEIC, CLSA Asia-Pacific Markets

YTD total FII investment (net) is around USD13.5bn, with the equity portion at

USD9.1bn and the debt portion at USD4.4bn (Figure 6). This is the second-

highest quarterly level of total FII inflow after USD15.5bn in 3Q10. However,

monthly inflows weakened significantly in March, and the outlook remains

uncertain. This in turn will affect INR and the pace of accumulation of foreign

reserves (Figure 7).

Figure 7: Foreign reserves and INR/USD

Source: Bloomberg, CEIC, RBI, CLSA Asia-Pacific Markets

(4)

(2)

0

2

4

6

8

Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12

(USD bn)

Equity Debt

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550

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100

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Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10 Jan 12

Foreign reserves

INR/USD (RHS)

(USDbn) (INR/USD, reverse axis)

FOREIGN RESERVES

AFFECTED BY RBI’S

CURRENCY INTERVENTION

FII INFLOWS MODERATED IN

MARCH

WE MAINTAIN OUR FORECAST

OF INR55:USD

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Figure 8: INR/USD and BSE Sensex

Source: Bloomberg, CLSA Asia-Pacific Markets

Figure 9: INR/USD and Brent

Source: Bloomberg, CLSA Asia-Pacific Markets

Figure 10: NRI deposits

Source: CEIC, CLSA Asia-Pacific Markets

35

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53

551,000

6,000

11,000

16,000

21,000

26,000

Jan 98 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10 Jan 12

(Index)

Sensex Index

INR/USD (RHS)

(INR/USD, reverse axis)

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49

51

53

550

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100

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Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10 Jan 12

(USD/bbl)

Brent

INR/USD (RHS)

(INR/USD, reverse axis)

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25

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45

50

55

60

(1.0)

(0.5)

0.0

0.5

1.0

1.5

2.0

Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12

(USD bn)(USD bn) NRI deposits: Net accretion

NRI deposits: Outstanding (RHS)

EQUITY PERFORMANCE WILL

IMPACT INR

GAIN IN JANUARY NRI

DEPOSITS DISAPPOINTING

HIGHER CRUDE OIL PRICE +

WEAKER INR TROUBLE

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Figure 11: Merchandise import cover of foreign reserves

Note: FY12 and FY13 are CLSA forecasts; Source: CEIC, CLSA Asia-Pacific Markets

Figure 12: Real effective exchange rate (REER) and INR/USD

Source: BIS, Bloomberg, CLSA Asia-Pacific Markets

 ©2012 CLSA Asia-Pacific Markets (“CLSA”). IMPORTANT: The content of this report is subject to and should be read in conjunction with thedisclaimer and CLSA's Legal and Regulatory Notices as set out at www.clsa.com/disclaimer.html, a hard copy of which may be obtained on requestfrom CLSA Publications or CLSA Compliance Group, 18/F, One Pacific Place, 88 Queensway, Hong Kong, telephone (852) 2600 8888. 01/01/2012

0

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FY81 FY83 FY85 FY87 FY89 FY91 FY93 FY95 FY97 FY99 FY01 FY03 FY05 FY07 FY09 FY11 FY13

(No. of months)

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Jan 94 Jan 96 Jan 98 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10 Jan 12

(INR/USD)(2010=100, Index)REER

INR/USD (RHS)

IMPORT COVER IS POISED TO

DECLINE FURTHER

CAPITAL INFLOWS RATHER

THAN REER APPEARS TO BE

THE KEY DRIVER OF INR


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