Factors leading to dollar strength in H1-CY18

*US GDP growth and PMIs have been indicating robust economic performance in 2018

*Rising benchmark rates coupled with rising yields fosters confidence in the US economy, leading to increased flows in the US market and an eventual stronger dollar in the first half of 2018

Rise in crude prices playing spoilsport

*Global oil supplies have increased at a moderate pace compared to global demand and it has led to a demand-supply gap of ~1mn barrels in 2018

*US has imposed sanctions on Iranian oil export keeping crude supply limited to countries like China and India

*As per International Energy Agency (IEA) estimate, OPEC surplus crude production capacity is going down and hence OPEC will have limited ammunition to counter supply outages, if any

*Any accidental outage like pipeline burst/technical failure can lead to steep surge in Brent prices

*Though Energy Information Administration (EIA) estimates demand and supply to match in 2019, considering rising demand from emerging markets (EMs) this gap may widen and pose further upside price risk

Domestic Factors Impacting Rupee
FPI/FDI Dynamics

*FPI flows which were supporting CAD, turn negative during March-July 2018, imposing more pressure on the rupee

*January-June 2018 witnesses $7.5bn FPI outflows (2017 FPI inflows – $31.4 bn)

*However, flows have turned positive for July and August showing renewed interest by FPIs

*FDI flows in Q1 FY19 stand at $9.3bn, 30 per cent more than Q1 FY18

Political uncertainty India

*Uncertainty about a single party emerging as the largest party in 2019 general elections in India has been acting as a dampener on market sentiments

*Additionally, state elections in Rajasthan, Chhattisgarh and Madhya Pradesh loom large ahead of the general elections

*Possibility of early elections to safeguard majority also not entirely ruled out

*The run-up to the elections may see increased spending, straining the fiscal balance US mid-term elections, November 2018

*Polls suggest Republicans could lose control of the lower House of Representatives, potentially crippling Donald Trump's agenda and increasing the chances of Democrats seeking impeachment proceedings

*Some of the states in which Trump secured unexpected victories in 2016 contain some of the most vulnerable seats in 2018

Factors which impacted rupee in recent past

*Stark overvaluation on a REER basis

*Dollar trength on back of QT, Fed rate hikes and robust US economy

*Sharp rise in global oil prices impacting trade balance. FII flows turning negative

*Sell-off in EM currencies, trade war induced worries

Factors in favour of a stable rupee

*Moderating CPI offers less scope for multiple rate hikes. Though CPI was rising linearly, it cooled off in the month of July

*Linear fall in food price inflation on back of structural fall in vegetable price inflation bodes well for CPI

*Both CPI and core CPI moderate in July owing to above

*This reduces the probability of more than one rate hike by RBI in FY19

FPI debt flows could support rupee

*At present dollar-rupee exchange rate, IN bonds offer attractive value proposition (compared to dollar/rupee at 64.60 and 10Y yield at 6.50 per cent in Jun-2017)

n As CPI is also expected to remain under control in future we can expect FPIs to participate in debt market

Signs of recovery by domestic economy

*IN GDP clocks GDP growth of 8.2 per cent in Q1 FY19. Manufacturing PMI has been consistently above 50.0 and has witnessed uptick from September 2017

*Q1FY19 marked sharp bounce in corporate earnings, after lacklustre performance in Q4FY18

*Eight core industries index, which tracks the eight basic industrial sectors has also shown a meaningful turnaround. Electricity generation, metals and cement sectors have performed well in the last 12 months

Upcoming scenario

*Depreciation in rupee is expected to continue in short term

*By September-end, expect dollar/rupee to move towards 73 with concerns related to EMs taking center-stage

*However, backed by robust consumption and stable equity markets we could see FPI/FDI flows to increase and negate trade deficit, keeping CAD in check

*While Q3 may see dollar/rupee at elevated levels (72-73), we expect dollar/rupee to retrace back towards 69-70 in Q4

What can go wrong

*Oil moves higher due to supply outages/constraints putting pressure on rupee

*Low intervention by RBI as it may allow rupee to come to fair value

*Domestic consumption increases sharply and FPI/FDI flows do not make up for increased trade deficit

*Trade war fuels more uncertainty in EMs. Continuation in EM currencies sell off to impact rupee

Source: Kotak Mahindra Bank