As rising oil prices combine with politics, rupee may fall to record low

Indian Prime Minister Narendra Modi and the rupee face a similar predicament -- old foes have re-emerged to keep them in check.

Brent crude rose above $80 a barrel last week for the first time since 2014, and is looking ominous for the nation’s budget deficit, inflation and the currency. Meanwhile, Modi faces the prospect of rival parties uniting to block his re-election bid after their success at a recent state poll.

Together, elevated oil prices and political uncertainty have sent the rupee 3 percent below the year-end analyst consensus targets, and some strategists expect the currency to weaken past a 2016 record low of 68.8650 per dollar. The combination couldn’t have come at a worse time, with rising Treasury yields spurring a selldown of emerging markets.

“Bouncing oil prices will add to India’s inflation woes and intensify market concern over the nation’s trade and current-account deficits,” said Qi Gao, a Singapore-based strategist at Scotiabank. He expects the currency to head toward 69 per dollar. The forecast is in the ballpark of the 69.63-to-70 range priced in by the onshore and offshore forwards markets.

Every $10 rise in the oil price worsens India’s current-account balance by 0.4 percent of GDP, pushes up inflation by 30-40 basis points, and hurts growth by about 15 basis points, according to Nomura Holdings Inc.

The currency rose 0.2 percent to 67.96 at 9:45 a.m. on Tuesday, paring the year’s loss to 6 percent. The consensus forecast is for the rupee to trade at 66 by the fourth quarter, and even the most bearish of analysts like Westpac Banking Corp. had only seen the rupee at 68.5, the estimates show.

FX Intervention

Further weakness in the currency could hurt capital inflows and pressure the current account deficit, said Aditya Pugalia, Dubai-based director of financial markets at Emirates NBD PJSC. Global funds have pulled $3.5 billion from Indian bonds so far this year, while flows into equities have shrunk to under $600 million after withdrawals of $1.6 billion since April 1.

The Reserve Bank of India probably burned through $8.4 billion of reserves in the four weeks through May 11 to halt the drop, data from the central bank show. Investors should expect more measures, including monetary tightening, according to RBC Capital Markets LLC.

“All tools are on the table, including regular FX intervention, other market operations and monetary policy,” said Sue Trinh, a strategist at RBC Capital in Hong Kong. She expects the rupee to trade at 65.20 to a dollar by the year-end.

The uncertainty spurred by an election-heavy year is also taking a toll. The outcome of this month’s poll in Karnataka, where the BJP was outsmarted by an opposition alliance despite securing the most seats, raised the prospect of rivals uniting to keep the ruling party out at the national ballot in 2019.

“While we do not expect a 2013-style panic (taper tantrum), the rupee performance could be constrained by concerns over increased fiscal spending ahead of state elections,” Nomura analysts including Craig Chan wrote, noting that the next key state elections aren’t due until late in 2018.