Outlook On Rupee Post-RBI Policy Meet And Current Global Backdrop

A key factor behind the rupee's strength has been strong inflows into the domestic capital markets that have more than compensated for the current account outflows. The inflows can be attributed to a large extent to the foreign investors chasing yields and to a lesser degree to superior fundamentals of the domestic economy. The Reserve Bank of India has not intervened aggressively to arrest rupee strength during a major part of appreciation as its ability to do so is constrained by the surplus liquidity situation and its hawkish outlook on inflation. The central bank has however protected the 64 handle against the US dollar with a great deal of intent and this is evident from the forex reserves figure which has reached an all-time high of $381 billion as on June 2.

Going forward, the outlook on rupee would depend on whether the FPIs (foreign portfolio investors) continue to pour money into domestic capital markets. This would depend on how the US yields move and the outlook on Indian rates. The Federal Open Market Committee's statement on June 15 would give an insight into the pace of rate hikes going forward. The Federal Reserve's twin mandates are maximum employment and price stability, both of which are inching towards their respective targeted mandates. The US central bank is therefore likely to sound upbeat on the economy and should remain on course for three hikes this year. This would support US yields and the US dollar.

The yield on the benchmark 10-year IGB has fallen to 6.52 per cent from 6.63 per cent post-policy. The move in OIS also seems to indicate that market is expecting at least another 25 bps repo rate cut from the RBI. As long as global risk sentiment remains positive, FPIs shall chase yields and pour money into domestic debt as fears of a rate hike have been put to rest at least for now. The threat to yields stems from the government not meeting its fiscal deficit target. This could happen on account of revenue loss due to rollout of GST (Goods and Services Tax) or further deterioration of state government finances due to a hike in minimum support prices (MSP) and farm loan waivers. The current debt limit utilisation status of FPI in central government securities stands at 86 per cent and therefore, there is further room for debt-related inflows. What can change the risk sentiment is a sudden spike in US yields on account of the Federal Reserve sounding hawkish or the Trump government pushing through much awaited reforms.

One should be wary of unwinding of carry trade when it happens (due to outflow of hot money) as it could be extremely severe. The entire rally in EM assets has been liquidity driven. This is evident from the fact that growth expectations have been subdued and commodities, especially base metals, haven't rallied much. If the dollar/rupee pair manages to break 64.90 and close above it, many FPIs would start booking profits and this profit-taking could easily snowball into panic unwinding. On the downside, the central bank 'put' at 64 is evident. The central bank may allow that level to break only if the rupee appreciates in line with other Asian and emerging market peers. This can happen if real rates in the US continue to drift lower (one can track the yield on US Treasury Inflation Protection Securities or TIPS as a substitute for real rates).

(Abhishek Goenka is the founder and CEO of IFA Global)

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