What will drive rupee in 2019

Risk sentiment is likely to be favourable if oil prices stay benign and the dollar index does not break out

The entire backdrop of global asset allocation trends and risk-return trade-offs has witnessed a sea change in the past two months. The catalysts for this significant shift have clearly been the recent fall in oil prices, which has been nothing short of miraculous, and the simultaneous unfolding of a global growth slowdown scare. But the severity of decline in oil prices, the change in global growth sentiment and the expected slowdown in US Fed rate hikes in the next year still do not fully explain the change, even after attributing it to various fundamental factors such as the supply glut caused by increased pumping by the Organization of the Petroleum Exporting Countries (Opec) in anticipation of the Iran sanctions or statements by US President Donald Trump. These are obviously cataclysmic shifts engineered by huge amounts of global liquidity being allocated to financial and commodity asset classes and the exaggerated responses that have become the order of the day ever since the days of the global financial crisis. 

While we can keep quibbling about the justification for the reasons and the magnitude of the change, it is clear that all these developments have been a blessing for the emerging market (EM) countries that run current account deficit, especially India. The main source of our woes were the twin concerns of higher crude prices and drying up of capital flows because of various reasons, ranging from political instability led by trade wars, divergent global monetary policy, gradual quantitative tightening led by the US, etc. Now suddenly there seems to be a let up in all of these. In addition, the apparent stabilisation in the Chinese yuan and some tentative expectations of a rapprochement in the upcoming G20 meeting between Mr Trump and his Chinese counterpart Xi Jinping are also supportive of EM risk assets even though there have been some hiccups in this as well.

Illustration by Binay Sinha

In sync with the change in the overall EM sentiment, the sentiment on the rupee has also seen substantial improvement in the near term. What does 2019 hold for the rupee and what are the factors that are going to drive the Indian currency? 

First, the downside risks to global growth that are emerging now, especially with a faltering Chinese economy, would in all likelihood lead to lower commodity prices. Other lead indicators such as global manufacturing PMI (purchasing managers' index) and export growth of Asian bellwethers such as South Korea and Singapore have also started slowing down. Given this backdrop, it is a reasonable expectation that crude prices would equilibrate at a relatively lower average price next year as compared to 2018. This takes off the additional stress of our current account. Our preliminary calculations suggest that the current account deficit for FY20 is likely to be in the range of $65 billion-$67 billion, mainly on crude price gains.

Second, 2018 has seen gut-wrenching volatility across asset markets and the biggest victim has been the EM space, with most EM currencies correcting bulk of their overvaluation this year. Overshooting in the forex markets during heightened risk aversion is natural and when the dust settles and valuations move towards reflecting actual fundamentals, some of the capital flows could move back in EM assets. While this premise seems counterintuitive when viewed against global growth slowdown and quantitative tightening, the issue is actually of nuance. The days of a surfeit of capital flows into EMs are probably behind us but even with global balance sheet tapering, there is still enough capital to flow into the countries with relatively sound fundamentals, including India. If portfolio flows were to revive in 2019 to a certain extent or even stay neutral, along with some inflows from the capital account relaxations made by the Reserve Bank of India (RBI) this year, we could see a modest surplus on our balance of payments. 

Third (and this could be the most crucial), the trajectory of the dollar index and the Federal Reserve’s rate-tightening path. Recently, there has been significant paring back of market expectations of further hikes. We believe it is too early for the Fed to abandon its path at the moment as signs of a slowdown are just that now — “signs”. They would likely pause only when there is a significant build-up of downside risks to growth. Till such time, the dollar will remain supported. However, next year onwards, other G4 central banks like the European Central Bank (ECB) would also stop buying bonds and euro area assets will then start yielding higher returns. When the divergence in monetary policy reduces, it would take away some of the steam from the current seemingly inexorable dollar rally. 

There are other factors to consider as well, such as increased US market borrowings to fund fiscal deficit and addition to duration as balance sheet tightening gains pace. These two factors could keep long yields on an upward bias, but corresponding support to currency could diminish as economic data starts to underperform expectations. This also has to be seen in conjunction with whether inflation moves up credibly or not over the year. 

The above framework looks complex and there seem to be too many moving parts even without taking into account the ubiquitous political uncertainties. However, on the margin, risk sentiment is likely to be favourable for EM assets and the rupee, if oil prices stay benign and the dollar index does not break out majorly. 

Domestic election risks also have to be factored into this mix. Election outcomes have massive market impact nowadays as was seen in Brazil and Mexico, recently. In the near term, the state elections and the run-up to the general elections in mid-2019 would be binary events for Indian asset markets.

We expect the rupee to trade mostly between 69.50 and 72.50 in the near term, and the Opec meeting, G20 meeting and election results would be in focus. Over the medium term, we could see some more appreciation, although we believe the RBI could replenish some lost reserves, and also protect some of the competitiveness gains that have accrued over the year on the back of the sharp nominal depreciation. 

The writer is group executive and head, Global Markets Group, ICICI Bank