Primary reasons behind the move and reasons which can take INR to 71-72 are as follows:
- Fed has been hawkish and rightly so since US economy is doing well. Inflation has been inching up and core CPI is above the Fed’s 2% target. Trump’s deficit induced spending plan is expected to create more inflation and hence FOMC has been hawkish. Maybe the time has come that high short-term borrowing cost will derail equity, credit market, and emerging markets. Argentina, Turkey faced the heat in 1stround followed by Brazil and South Africa. Now turn for other EMs including India.
- Fed’s balance sheet reduction plan would hit 50 billion per month from next quarter, at a time when the US government is slated to borrow 800 billion more. Rising US yields have always been a drag on EM, and the initial spike in USDINR was a result of the rising US yields. From October onwards, ECB would also taper their QE, and there would be a net reduction in central bank liquidity from thereon.
- Tariff wars have created uncertainty about global growth. Specifically, a trade war with China can escalate quickly if Chinese decide to take on aggression from Trump. Yuan has been depreciating (almost 6% from the recent peak) and any official devaluation action can create a shock wave in markets.
- 2019 Political uncertainty since it’s an election year: This factor is not critical now but will eventually play out closer to the year-end. In a scenario of weakening rupee and inflation, any popular moves by the government before elections could be frowned upon by markets. Recent BJP performance has created uncertainty around the next election result
- Our monthly CAD has deteriorated to USD 5 bn. a month. While the deficit is significantly higher than last year it still can be financed by FDI of 3bn a month and FPI of 24 bn annually. Problem is if in some months FPI pulls out then RBI has to aggressively chip in. How aggressive RBI will be depending on Peer currency movement and we have to keep a close watch on RBI’s behavior and make judgment calls. LOU ban also has created an additional USD demand to the extent of 25 billion for this year. At least the Fx reserves are good enough for a sustained intervention from RBI – this is one of the factors keeping the Rupee from a run-away move such as in 2013. A factor which can impede a large RBI intervention is the fear of US labeling India as a currency manipulator, given the environment of Trade wars.
- Oil price moving up to 75 level has led to CAD increase and oil price moves to 100 plus levels that will be stressful for INR. The oil price has already started feeding into inflation which is again negative for INR.
Reasons which can bring back stability in INR
- USD 5 bn. Of CAD can be financed comfortably considering India’s interest rate is high and GDP growth is strong. Even if risk aversion and Dollar strength subside to an extent, India is considered a good investment destination would continue to attract flows.
- If RBI comes up with aggressive intervention plans like NRI bonds or some similar scheme that should be stabilizing markets. There are rumors of 30-35 billion worth of such bonds.
- Fed can also become less hawkish if trade war or high-interest rate starts impacting US markets. While Fed is concerned about inflation, a sharp correction in US markets can lead to a tapering of their hawkishness – helping EM.
- The government may push to keep INR sub 70 since a section in India associates INR strength with National Strength and we are approaching an election year. A 70 plus level will look too bad for the current Government’s election performance in the eyes of those who associate nationalism with Rupee strength. Our view is overall current Government / Ministers / RBI will be highly inclined to intervene and stabilize INR
View + Strategy
- As of now, negatives outweigh the positives for the Rupee. Most of the large movements of the past were due to global factors. Sustained USD strength and high US yields have always been bad for INR and unfortunately for the currency, USD strength is occurring at a time where trade war uncertainties are right up front in market’s focus.
- Even if INR has to go to 71-72, there will be strong resistance at 70 levels. If Fed becomes accommodating, then INR may retrace back to 67.00 levels and stay there for a while for eventual move towards 70 plus levels.
- The strategy has to be made in such a way so that the company has the highest probability of meeting objective irrespective of INR moving to 74.00 or 64.00 or a narrower range of 67.00 or 71.00
- A Call spread from 69.00 to 70.00 or a Seagull with 69.00 to 70.00 and some possible upside till 67.50 or 68.00 will be a good strategy. It will protect from immediately move if any towards 70.00. While RBI intervenes and protects a level, the company can figure out how to manage the risk of 70+. Call spread / Seagull, however, requires close monitoring
- Alternatively, a long vol out of the money plain call strategy for short term will also work well. An out of the money call option will provide low cost and will protect from any accidental movement while the benefit of appreciation can be enjoyed by the company. This has been historically proven as a good strategy.
- If the imports are for longer tenor like 6M or 9M the same should be hedged using short-term options with rollover because in a current market short-term volatility needs to be managed and views will evolve. Better to take one step at a time.
- Even if INR has to depreciate to 71, 72 or 74 levels – eventual stability can be expected compared to forward levels. Hence a slow SIP approach of hedging long-term exports (1Y or so) is a good strategy. The premiums for 12M is almost close to 300 paisa or 25 paisa a month. The hedging should be done for longer duration and early utilization to be done for near term receivables conversion. For example, current 1Y forward is almost at 72.00 and if INR moves to 72.00 the forward rate will be 75.00. So a SIP should be able to catch an average 73.50 kind of level for 12M and we believe that should pay off.
- Another good strategy for exports is in the money Put option for short-term with roll over. If 1M forward is at 69.25 then plain put strike 69.75 will cost around 75 paisa upfront. Once these 75 paisa is paid making the minimum rate as 69.00 (69.75 less 75 paisa) then there is no fear of INR depreciation. Even if INR moves to 74.00 the company can sell at 74.00 and there is no obligation. In the current market of high volatility, paying 25 paisa extra to retain the optionality is a good strategy however the company should be prepared to pay the upfront option cost.
For further discussion please contact Samir Lodha @ 9619188995 or [email protected]