INDIAN RUPEE: THE END OR MERELY A BEND? RISK REWARD NOT GREAT FOR INDIAN RUPEE LONGS; NOT EVEN WHEN EQUITIES RECOVER

THE END OR MERELY A BEND

The Indian rupee tanked 27% in the year to November 20, 2008 to reach an all time low of 50.12 versus the U.S. dollar. Over the last 30-days, the INR recovered about 6% to close at 47.05 on December 19. A key question is whether 2008 marks the end of the appreciation cycle that began in 2002.

In my view, the lofty INR levels seen in early 2008 will likely not be reached again over the next 5-years. The base case for the first half of 2009 is a retest of the 50 level. Beyond that, longer-term exchange rate expectations should remain geared to further weakness.

THE RESERVE BANK MANAGES THE CURRENCY IN THE CONTEXT OF A BROAD-BASED REAL EFFECTIVE EXCHANGE RATE; INDIAN RUPEE APPEARS FAIRLY VALUED

The RBI’s 36-country real effective exchange rate (1993-94 =100) fluctuated in a band of +/-5% over the last 16-years. In September 2008, the INR appeared undervalued by about 3.4%. In the period from September to December 19, the broad dollar index gained 6.5%, while the Indian rupee lost only 3.3%. The INR seems fairly valued right now and the future would crucially hinge on the direction of the U.S. dollar.

REVIVAL OF CAPITAL INFLOWS INTO EQUITY MARKETS WILL NOT TURN THE TIDE; THE RUPEE IS NOT AN INDIA STORY

The reversal of the INR’s fortunes coincided with portfolio capital outflows from equities. While the exchange rate continues to display high correlation with stocks, a sustained equity revival would not be accompanied by renewed rupee strength, in my view.

Instead, the outlook hinges on accurately forecasting the U.S. dollar. In 2008, the INR merely reflected the negative correlation between the U.S. dollar and risky asset performance. The dollar benefited from the status of treasuries as the ultimate risk free asset. Net private purchases of treasuries measured $253 billion in the 12 months to October 2008 versus $198 billion in 2007 and $126 billion in 2006. Additionally, with inter-bank dollar liquidity strained, it remained difficult to borrow and sell dollars. A natural conclusion seems to be that once the financial system stabilizes, the dollar slide will resume.

There is merit to this argument, but other developments underway suggest that a sustained recovery in risky assets will only mute the rise of the dollar, but not reverse the ascendancy.

THE U.S. CURRENT ACCOUNT DEFICIT IS CORRECTING; NEGATIVE WEALTH EFFECT CURBS CONSUMER SPENDING

After adjusting for crude oil imports, the U.S. trade deficit corrected by $85 billion during January-October 2008 compared to the same period last year. This trend will likely continue as declining housing and equity wealth force U.S. households to save. Restrained credit should also work to limit spending expansion.

NEAR-TERM DOLLAR VIEW SEEMS ECONOMY NEUTRAL

The Fed cut rates to 0%-0.25% (basically zero) last week. The U.S. authorities remain the most aggressive in providing policy stimulus. The outcome for the dollar seems economic outlook neutral; at least in the near-term. If aggregate demand responds to the measures taken so far, rates will rise relative to the rest of the world and the currency will climb. On the other hand, if spending remains moribund, then there will be another leg down in the global economy and the ECB and BOE will be forced into near ZIRP. Relative yield dynamic will favor the U.S. in this scenario as well.

THE BASE CASE: A U.S. LED GLOBAL RECOVERY COUPLED WITH DOLLAR STRENGTH

Global growth leadership outside the United States seems difficult to visualize. This point figures particularly pertinent in the face of the current account adjustment underway in the U.S. The last similar phase of U.S. current account adjustment stretched from 1987 to 1991. Rapidly growing Germany and Japan saved the day then. Such a state of affairs looks remote today.

Germany, Japan and China remain export-led. Other large current account deficit countries such as the U.K., Ireland and Spain suffer from their own housing busts. The best case for the global economy would be that extraordinary policy actions in the U.S. make the current account contraction more protracted. This would give the world more breathing room, enabling a feeble economic resurgence.

In this scenario, rate differentials will incrementally shift in the favor of the U.S. and that coupled with the dipping trade deficit will propel the dollar higher.

INFLATION TAIL OUTCOME MORE LIKELY THAN DEFLATION

What if monetary policy remains ineffective? With the financial system clogged, there is a positive probability that substantial base liquidity does not percolate into the system. In this low likelihood scenario, policy makers in the U.S. would prefer inflation to deflation. In a debt laden economy, there is really no choice. The Fed will continue undertaking unconventional policy actions to stoke inflationary expectations. Large monetized budget deficits would be the natural course to pursue. It is hard to imagine how other democratic governments will defend tight policy in the face of large scale job losses. The winners will be gold and hard assets in this scenario.

RISK REWARD NOT GREAT FOR USD/INR SHORTS

If the broad dollar index remains unchanged for the next 5-years, the INR will depreciate in line with inflation differentials – about 3% per year. More likely, generalized greenback strength will cause losses more than 3% per year.

In light of the above, for strategic short USD/INR trades; it seems more like the end of the road.