Pictures at an exhibition: Markets are generally anything but neat

The accompanying graphic shows the movement of INR and EUR against USD over the past two years. At first glance, it may appear that both currencies move in a reasonably correlated fashion, suggesting that the rupee responds quite closely to global movements of the dollar (against the Euro). However, a closer look reveals there was no significant—less than 70%—correlation between INR and EUR around 80% of the time.

The second part of the graphic articulates the story even more loudly. The three lines show the correlation of EUR with INR, GBP and JPY, respectively. GBP and EUR have a reasonably strong correlation (average 74%), reflecting the fact that they generally move together against USD. JPY is also reasonably strongly correlated, except for the past six months, where it ran to its own tune—the average correlation was 64%.

Unsurprisingly, the correlation path of the rupee looks nothing like the other two, reflecting RBI’s imperatives to keep the rupee weaker than or stronger than particular levels, depending on global volatility and domestic competitiveness and liquidity considerations. Clearly, RBI’s usual line that “we don’t target any specific level of the rupee, we only intervene to control volatility” is not reflected in reality. For short periods—the flattish lines at the top—the rupee did move with the Euro, rising when the dollar was weak and falling when it was strong. But for most of the time, the relationship was indeterminate, including periods (when the correlation was negative) when the rupee strengthened when the Euro was weak and vice versa.

Indeed, this separation of paths is likely to get even starker. Currently, global sentiment is for the dollar to get weaker—perhaps, much weaker. Already DXY is threatening to fall below 90, and EUR-USD has broken above 1.2150, a level not seen since early 2018; and, of course, there are several celebrated analysts calling for a weak dollar over the next few years. If we assume that the DXY were to fall below 85 and EURUSD to break to 1.28—there are no technical stops in either case—RBI would come under increasing pressure to keep the rupee from breaking higher.

The rupee’s exchange rate is already uncompetitive and, perhaps as another expression of the dollar’s weakness, global investment sentiment is flashing risk-on quite loudly—even though cases of coronavirus continue to rise in many countries, the vaccines are here (!), and most economies are expected to reflate strongly in 2021. Thus, equity portfolio flows, which have been averaging nearly $500 mn a day since the start of November, would likely continue strong.

Secondly, and perhaps more importantly, the government appears to have completed the groundwork to enable a set of G-Secs to be included in global bond indices, whose announcement was made in the last budget. This could open up the gates for a new set of investors—institutional debt investors who are only permitted to invest in bonds where there are no volume constraints on liquidity. We note that debt inflows thus far have been flat since the start of November.

Thus, the pressure on the rupee to appreciate is likely to increase. As it is, the reserves have risen by over $100 bn in 2020, and, while some of this is related to the weakness of the dollar (non-USD reserves rise in value in dollar terms), the vast bulk of this has been the result of RBI buying inflows to prevent “undue” appreciation of the rupee. Of course, and despite RBI’s market efforts, this has resulted in the continuing surge in domestic liquidity, and inflation remains elevated.

To be sure, part of this is because of still sticky supply-side constraints and the fact that growth is still sluggish. In particular, imports are still weak, which is a blessing from this point of view since the global economy is also turning inflation positive. A wide assortment of industrial raw materials has risen sharply in the past few months, and, most recently, copper—the granddaddy of all—has shot to levels not seen since 2013.

Given all this, it is hardly surprising that all analysts who had been forecasting more interest rate cuts since October this year have backtracked and some of them now see the next move in interest rates, albeit in 2022, to be upwards. Forecasts for the rupee, too, all point in the same direction—upwards. Nomura recently put out a report forecasting USD-INR at 70.60 at the end of 2021.

It all fits very neatly into the picture painted above. But, markets are generally anything but neat. Thus, exporters should continue to follow a systematic programme of hedging with a risk limit and regular hedges; importers, for whom the story will be very, very tempting, should avoid staying 100% open unless they have the discipline to set and follow a well-designed stop loss.

www.mecklai.com
CEO, Mecklai Financial. Views are personal