Over the last 3 months, the rupee has depreciated 4-5% against the US dollar. The rupee has remained largely steady against the US dollar over the last few years, which is contrary to long term trends. Theory says that the rupee should depreciate against the dollar over long periods of time at a rate of about 3-4% p.a. which is in line with the inflation differential between the two countries. Since 1993 the rupee has depreciated against the dollar by roughly 3% p.a.
However, this expected depreciation of the currency is not a smooth affair and is punctuated by volatility, largely on account of factors like the current account deficit and the capital flows into the country. The largest component of the current account deficit is the trade deficit which is the difference between the total goods and services exported by a country and the total goods and services imported by the country. Remittances and other transfers make up the rest. India’s trade deficit this year (including invisibles, a large item of which is IT services exports) is estimated at $48 bn. This is up sharply from $15bn last year though short of the record USD $88bn in FY2013. One of the important factors affecting the trade deficit is that oil prices are up sharply in recent months, due to higher global growth and a curtailment of supply by producers. Brent oil futures, which were trading at about $50-55 a year ago, have climbed into the mid-70s and this causes some strain on India’s trade deficit. Traded good exports grew at 10% last year but imports grew a higher 20%. Oil imports are up 25.5% and non-oil imports are up 17.9%. The other factor affecting India’s current account is that ‘invisibles’ which consist largely of IT services exports and remittances, has shown a slowdown in growth after showing remarkable growth in earlier years.
The current account deficit is normally bridged by capital inflows – FDI and FII. FDI inflows have bumped up in the last few years from the roughly $20bn levels 5 years ago to about $40bn levels currently. FII equity flows which have ranged between $10-$20 bn over the last many years, slowed down to a roughly $2bn pace in FY2018. FII Debt flows have been strong at roughly $20 bn. On the whole, capital inflows continue to be stable.
In 2013 the Indian rupee witnessed a lot of volatility and touched the 68 to the dollar mark. Since then, the rupee has done rather well and has actually appreciated marginally over a 5 year period – the last time one remembers such a long steady period for the rupee is during the 2004-2007 period when emerging market flows were very strong.
One way to gauge the valuation of the rupee with respect to its trading partners, is to look at the REER, or the Real Effective Exchange Rate data, which the RBI publishes regularly. The most frequently observed readings of the REER on 36 Currency Trade based weights are somewhere between 99 and 120 over the last 10 years. In December, 2017 the reading was at 122.6 and was at 117.4 as on March, 2018. The higher the value of the REER the more overvalued we can expect the rupee to be and this may be exerting some pressure on the rupee.
A depreciating rupee has twin effects – it benefits exporters and increases the cost of imports thus also feeding into inflation. From our portfolio perspective, since we have some IT services companies and pharmaceutical exporters in the portfolio, we believe the portfolios are sufficiently protected against any major weakness in the rupee, and are even likely to benefit.