India’s currency has remained relatively stable – and is forecasted to remain so. INR strength can unlock significant capital flows
Over the course of last year, we have touched upon the topic of the Indian rupee (INR) a few times: (a) in April, we noted India’s better inflation dynamics compared to the developed world feeding into lower inflation, and yield, differentials, and (b) in July, we noted that not only is the depreciation of the INR moderating, but the volatility in the currency has also been at decadal lows.
The July piece concluded: Lower depreciation coupled with lower volatility, if sustained, can bring down the required risk premium that foreign investors charge on Indian investments. Savings on the lower cost of capital can be material. Such reduced cost of capital can be attributed to the deft management of the external value of the rupee. The central bank, through the course of the last couple of years, has managed its large stockpile of foreign reserves countercyclically to dampen the volatility. The RBI has consistently maintained its mantra on foreign exchange: to “not target a level but manage volatility”.
Reviewing this after half-a-year, we note that the INR has traded in a small range: on Jul 1, INR closed at Rs 82.0 to the US dollar (USD) and on Feb 12, 2024, it traded at Rs 83.0 to the USD. INR has seen this trend of stability, or in some cases, marginal appreciation, across developed world currencies. We continue to attribute the relatively stable performance of the INR to the better inflation dynamics in India coupled with large foreign exchange reserves, which has benefitted from a positive balance of payments.
Looking forward
To understand the longer-term direction of INR, we turn to two sources: (1) how are long-term forecasters thinking about the currency, and (2) how is the market pricing it. Both suggest that INR is expected to continue in a relatively stable zone.
The forecasts
The IMF multi-country models try to mimic the real world as closely as possible: forecasts made by IMF consider the recursive interplay of the variables of one country on the world economy. A single country model may sometimes miss this interactive nature.
In its half-yearly World Economic Outlook (WEO), IMF projects various facets of the global economy. This includes forecasts on the gross domestic product (GDP) of various countries in their local currencies and USD over the next five years. While the IMF does not make formal forecasts of exchange rate, implied forecasts can be derived from these projections (by dividing the local currency GDP estimates by the USD estimates). Once we know the absolute values of the forecasted exchange rates, we can calculate the expected change (appreciation/depreciation) of the currency. Since the IMF has been consistently publishing these reports for many years, one can go back in time and look at such implied forecasts.
As we note in the accompanying chart, the WEO in October 2023 made a remarkable change in the forecasts of INR vis-à-vis the USD. Over the last three years, their forecasts for the depreciation of the INR have been consistently narrowing: from around ~3%-3.5% pa in 2021 to a less than 1% pa depreciation forecast in Oct 2023. In absolute terms, this means that the forecast of the IMF for the USD-INR pair for year 2028 is Rs 83.90.
It is pertinent to note here that the December 2023 Article 4 consultation of the IMF attracted attention, especially because of the rejoinder statement written by India’s Executive Director at the IMF which noted that “staff characterization of India’s exchange rate as a ‘stabilized arrangement’ is incorrect and inconsistent with reality.” We look forward to the April 2024 WEO forecasts to see how IMF sees the INR going forward.
The markets
While the forecasters do a periodic update on their estimates, the market makes a daily assessment of the spot and future. The cost of hedging the USD-INR pair has been trading at multi-decadal lows for the last many months. The cost of 1-year forward hedge is now down to 1.8% from the 8.0% average in CY2014. The trend of lower cost of hedging is now prevalent across longer tenure too. This reflects the market’s assessment that the depreciation in the INR is expected to be limited. [Without being too obtuse, it has been noted that typically the realized depreciation of a currency turns out to be lower than the cost of hedging.]
Implications
If the INR were to remain relatively rangebound and stable as the forecasters and the markets expect, this can bring down the cost of capital. A significant risk premium attached with any country is the depreciation and volatility of its exchange rate. Long-term investors may want to observe a few quarters of consistency before changing their assumptions about INR’s movement. However, once the assumption changes, it could unlock a significant inflow of capital. A stable, less depreciating currency also helps in India’s goal of reaching its USD targets of GDP faster.
A concern typically raised when currency remains stable is whether exports suffer. As the recent Collection of Essays, Re-examining Narratives, by the Chief Economic Advisor highlighted, “income elasticity of exports is 3.44 (for the period 2009-2022) …and the price elasticity of exports is (-) 0.4 over this time.” India’s exports respond more to the changes in global growth than relative strength of the currencies. India’s investment in improving its productivity of factors of production can obviate the challenge, if any, from a relatively stronger currency.
With research inputs from Akshata Kalloor. The author is with the National Investment and Infrastructure Fund Limited. Views are personal.
