Rajeev Malik

+65 64167890

rajeev.malik@clsa.com

29 March 2012

Rupee woes
INR REMAINS VULNERABLE

INR remains one of the riskiest currencies. Indias large and widening current account (CA) deficit and its dependence on volatile capital inflows make it vulnerable to becoming a casualty of swings in global risk appetite and crude oil prices. INRs recovery in January was due partly to RBIs aggressive currency intervention, although global risk-on, RBIs antispeculative measures and deregulation of NRI deposit rates also helped. However, INR has been weakening against USD since early February, despite a surge in portfolio inflows into India (1Q12: around USD13.5bn). Global risk-on will likely boost volatile capital inflows unless domestic factors, such politics and policy coordination, are turn-offs. But capital inflows may not be adequate to eliminate concerns about smooth financing of the CA deficit. On our forecast, the CA deficit of 3.9% of GDP in FY13 is beyond the RBIs comfort level. This, along with our expectations of a stronger dollar, sets the stage for INR to weaken. We maintain our end-2012 forecast of INR55:USD. INR has had an exceptionally volatile ride (Figure 1). It slumped to nearly INR54:USD in mid-December before recovering to INR49:USD by midFebruary due to a combination of an unexpectedly strong jump in portfolio inflows triggered by global risk-on and RBIs desperate measures, including aggressive currency intervention in January. However, it weakened subsequently and has broken above the 51-mark despite USD weakness. The pace of capital inflows has slowed recently even as the CA deficit remains large. In the absence of meaningful RBI currency defence, INR had to weaken.
Figure 1: ADXY Index and INR/USD
125 (Index) ADXY Index 120 INR/USD (RHS) (INR/USD, reverse axis) 35 37 39 41 115 43

EXCEPTIONALLY VOLATILE RIDE FOR INR

YTD INR HAS DEPRECIATED MORE THAN ADXY

45
110 47 49 105 51 53 100 Jan 08 55 Jan 09 Jan 10 Jan 11 Jan 12

Note: Rise in ADXY indicates appreciation. Source: Bloomberg, CLSA Asia-Pacific Markets

ECONOMICS RESEARCH

India unplugged
29 March 2012

INRs performance in recent months has been similar to that of some of the risky EM currencies (Figure 2). This suggests an understandable strong global risk on/off dimension that is complemented by domestic factors. For example, the turning point for INR in December is not substantially different from that of other EM currencies, despite the RBIs anti-speculative actions and deregulation of NRI deposit rates.
INR BEHAVING SIMILAR TO
OTHER RISKY EM CURRENCIES

Figure 2: Emerging markets exchange rate

130 125 (Index, 1 Jan 2010 100) Russia - RUB/USD India - INR/USD Brazil - BRL/USD Turkey - TRY/USD

120
115 110 105 100 95 90

85
80 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12

Source: Bloomberg, CLSA Asia-Pacific Markets

INR AT THE MERCY OF CRUDE

OIL PRICE AND CAPITAL INFLOWS

Looking ahead, three key factors will affect the outlook for INR. First, sustainability of global risk-on and its impact on international crude oil prices and capital inflows into India. Higher crude oil prices widen the CA deficit but higher capital inflows due to global risk-on temporarily ease the financing pressure. Every USD10/bbl increase in crude oil adds around USD10bn (0.5% of GDP) to the CA deficit. As highlighted in Figure 3, we expect the CA deficit to widen to USD73.1bn or 3.9% of GDP in FY13 from an estimated USD66.6bn (3.7% of GDP) in FY12.
Figure 3: Current account deficit
80 (USD bn) (% of GDP) 5 4

CA DEFICIT TO WIDEN TO A
RECORD HIGH

70
60

Current account deficit

Current account deficit % of GDP (RHS) 3 2 1

50
40 30 20 10 0 (10) (20) FY91 FY93 FY95

0 (1) (2)
(3) FY97 FY99 FY01 FY03 FY05 FY07 FY09 FY11 FY13

Note: FY12 and FY13 are CLSA forecasts; Source: CEIC, CLSA Asia-Pacific Markets

rajeev.malik@clsa.com

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29 March 2012

But no economy with a large CA deficit should rely mainly on portfolio inflows to finance the deficit as these inflows can be uncertain. Also, it is unlikely that capital inflows will comfortably and smoothly finance the wider CA deficit in FY13.
STRONGER USD WILL BE
NEGATIVE FOR INR

Second, outlook for USD. We expect USD to strengthen in 2H12, which in turn should be negative for INR. Note that INR has weakened in recent weeks despite USD weakness (Figure 4). Such an outcome does not boost confidence.
Figure 4: INR/USD and DXY index
95 90 85 (Index) DXY Index INR/USD (RHS) (INR/USD, reverse axis) 35 37 39 41 43

INR HAS DEPRECIATED

RECENTLY DESPITE USD WEAKNESS

80
75 70 65 Jan 05

45
47 49 51

53
55 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12

Source: Bloomberg, CLSA Asia-Pacific Markets

Third, RBIs intervention in the currency market to support INR, if capital inflows are inadequate to finance the CA deficit. Currency intervention to prevent depreciation of the exchange rate is a losing proposition that will leave the central bank with a combination of a decline in its foreign reserves and a still-weak currency, and could also be an invitation for a speculative attack.
RBI UNLIKELY TO INTERVENE
AGGRESSIVELY

Figure 5: RBIs currency intervention and INR/USD

15 (USD bn) (INR/USD, reverse axis) 38

10 5 0 (5) (10) (15)

(20) Jan 05

RBI's net sale/purchase of USD

INR/USD (RHS)

40 42 44 46 48 50 52
54

Jan 06

Jan 07

Jan 08

Jan 09

Jan 10

Jan 11

Jan 12

Note: Positive number means net purchase of USD; Source: Bloomberg, CEIC, CLSA Asia-Pacific Markets

rajeev.malik@clsa.com

India unplugged
29 March 2012

RBI has been aggressive in supporting INR with heavy USD selling at USD7.3bn in January, only slightly lower than the currency intervention of USD7.8bn in December (Figure 5). However, looking ahead, RBI is unlikely to prevent INR from adjusting because of inadequate capital inflows, although it is likely to manage INR better than it did late last year.
WE MAINTAIN OUR FORECAST
OF INR55:USD

The combination of above three factors suggests to us that INR is poised to weaken. We reiterate our end-2012 forecast of INR55:USD but the ride will be volatile due to shifting global risk appetite.
Figure 6: Net FII Debt and Equity

FII INFLOWS MODERATED IN MARCH

8
6 4 2

(USD bn) Equity Debt

0
(2) (4) Jan 07

Jan 08

Jan 09

Jan 10

Jan 11

Jan 12

Note: March 2012 data up to 28 March; Source: CEIC, CLSA Asia-Pacific Markets

YTD total FII investment (net) is around USD13.5bn, with the equity portion at USD9.1bn and the debt portion at USD4.4bn (Figure 6). This is the secondhighest quarterly level of total FII inflow after USD15.5bn in 3Q10. However, monthly inflows weakened significantly in March, and the outlook remains uncertain. This in turn will affect INR and the pace of accumulation of foreign reserves (Figure 7).
FOREIGN RESERVES AFFECTED BY RBIS
CURRENCY INTERVENTION

Figure 7: Foreign reserves and INR/USD

350
300 250 200 150 100 50

(USDbn)

(INR/USD, reverse axis)

35
37

Foreign reserves
INR/USD (RHS)

39
41 43 45 47

49
51

53
55 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10 Jan 12

0 Jan 00

Source: Bloomberg, CEIC, RBI, CLSA Asia-Pacific Markets

rajeev.malik@clsa.com

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29 March 2012

EQUITY PERFORMANCE WILL IMPACT INR

Figure 8: INR/USD and BSE Sensex

26,000

(Index)
Sensex Index INR/USD (RHS)

(INR/USD, reverse axis)

35

37
21,000 39 41 43 45

16,000

11,000

47
49

6,000

51
53

1,000 Jan 98

55 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10 Jan 12

Source: Bloomberg, CLSA Asia-Pacific Markets

HIGHER CRUDE OIL PRICE + WEAKER INR TROUBLE

Figure 9: INR/USD and Brent

160 140 120 100 80 60 40 20 0 Jan 00 Brent INR/USD (RHS)

(USD/bbl)

(INR/USD, reverse axis)

35 37 39 41

43
45

47
49 51 53 55

Jan 02

Jan 04

Jan 06

Jan 08

Jan 10

Jan 12

Source: Bloomberg, CLSA Asia-Pacific Markets

GAIN IN JANUARY NRI

DEPOSITS DISAPPOINTING

Figure 10: NRI deposits

2.0 1.5

(USD bn)

NRI deposits: Net accretion

(USD bn)

60 55 50

NRI deposits: Outstanding (RHS)

1.0
0.5 0.0 (0.5) (1.0) Jan 05

45 40

35 30 25
20 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12

Source: CEIC, CLSA Asia-Pacific Markets

rajeev.malik@clsa.com

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29 March 2012

IMPORT COVER IS POISED TO

DECLINE FURTHER

Figure 11: Merchandise import cover of foreign reserves

18 16 (No. of months)

14
12 10

8
6 4

2
0 FY81 FY83 FY85 FY87 FY89 FY91 FY93 FY95 FY97 FY99 FY01 FY03 FY05 FY07 FY09 FY11 FY13
Note: FY12 and FY13 are CLSA forecasts; Source: CEIC, CLSA Asia-Pacific Markets

CAPITAL INFLOWS RATHER THAN REER APPEARS TO BE THE KEY DRIVER OF INR

Figure 12: Real effective exchange rate (REER) and INR/USD

110

(2010=100, Index)

REER INR/USD (RHS)

(INR/USD)

55

105 100 95 90 85

50

45

40

35

80
75 Jan 94 30 Jan 12

Jan 96

Jan 98

Jan 00

Jan 02

Jan 04

Jan 06

Jan 08

Jan 10

Source: BIS, Bloomberg, CLSA Asia-Pacific Markets

2012 CLSA Asia-Pacific Markets (CLSA). IMPORTANT: The content of this report is subject to and should be read in conjunction with the disclaimer and CLSA's Legal and Regulatory Notices as set out at www.clsa.com/disclaimer.html, a hard copy of which may be obtained on request from CLSA Publications or CLSA Compliance Group, 18/F, One Pacific Place, 88 Queensway, Hong Kong, telephone (852) 2600 8888. 01/01/2012

rajeev.malik@clsa.com