Case for a stronger rupee: Why the INR will only weaken 2% each year

The Indian Rupee (INR) has defied expectations by exhibiting remarkable stability recently. This is particularly surprising considering the historically small difference between interest rates in India and the United States. Typically, a lower interest rate in India compared to the US would weaken the rupee as investors seek higher returns elsewhere. However, several factors are contributing to the rupee's unexpected strength, suggesting a more optimistic outlook for the Indian currency in the coming years.

Analysts at Kotak Alternate Assets predict the rupee will only weaken a little bit each year in the future, around 2%. This is much slower than the historical average of nearly 4% weakening per year.

"Despite the historically low-interest rate differential between the US and India, the Indian rupee has exhibited minimal volatility. Additionally, India's improved foreign reserves bolster confidence in the RBI's ability to manage external shocks," said a report by Kotak Alternate Assets. 

Moreover, as the depth and breadth of Indian financial market improves, heighted FPI inflows into various asset classes may help to bolster the RBI’s reserves, it added. Government borrowings have remained largely constant for the past four years (post the pandemic led surge) and current account deficit has also surprised positively. Overall, political risk premium for India is falling with timely intervention by the RBI helping to instil further confidence in the rupee stability.

The brokerage lists eight reasons for its stability and expected slower depreciation:

Strong Foreign Exchange Reserves: India boasts a comfortable level of foreign currency reserves, giving the Reserve Bank of India (RBI) more power to intervene in the forex market and stabilize the Rupee's value.

Improved Financial Markets: The depth and breadth of India's financial markets are improving, attracting increased foreign investment in stocks and bonds. This inflow of foreign capital (FPI) further strengthens the Rupee.

a.) India’s weight in the MSCI EM index has jumped to about 18.2% from about 9.4% in 2018. On the other hand the FPI ownership of BSE 500 has fallen to about 17% which is lowest since 2012. "As the equity market broadens and deepens

with rising float, the FPI flows in equities may remain buoyant, in our view," said Jitendra Gohil - Chief Investment Strategist at Kotak Alternate Assets.

b.) With the addition of Indian bonds in global bond indices, it is expected that India may attract about $100 billion foreign funds. FPI owns just 2% government bonds and this is expected to rise to about 6.7% by 2027, still much lower than other EMs.

c.) FDI flows in India has remained benign in FY2024 in line with global trends. However, India is fast emerging as the global manufacturing destination. India is set to receive $100 billion worth of investment from the four European Free Trade Association (EFTA) (Norway, Switzerland, Iceland and Liechtenstein) countries under the terms of their free trade agreement (FTA). This translates to an annual Foreign Direct Investment (FDI) of approximately USD 7-8 billion.

Reduced Government Borrowing: Government borrowing has remained steady since the pandemic surge, demonstrating fiscal discipline and reducing investor risk perceptions.

Lower Current Account Deficit: The current account deficit, which measures the net outflow of money from India, has been surprisingly low. This reduces pressure on the Rupee. "Government has embarked on import substitution and export promotion policies. We expect the CAD should largely be controlled below 1% in the next few years, said Kotak.

"Government gross borrowing is constant since covid year (FY 2021) despite size of GDP growing by 50% to Rs 300 trillion," said Kotak Asset.

India's Strong Economic Outlook: India is projected to have a much lower probability of recession compared to major economies like the US, China, and Europe. This relative economic stability attracts investors seeking safe havens for their money.

Falling Political Risk Premium: India's ongoing economic reforms, including a declining debt-to-GDP ratio, are leading to a potential credit rating upgrade in the coming decade. This reduces the "political risk premium" associated with investing in India, making it more attractive to foreign investors.

Active Central Bank Intervention: The RBI has been actively managing the forex market to maintain a stable exchange rate and instill confidence in foreign investors.

Potential Risks to Consider:

Rising Oil Prices: A significant increase in global oil prices, especially above $100 per barrel, could put pressure on the Rupee as India is a major oil importer.
 

Chinese Yuan Depreciation: A sharp devaluation of the Chinese Yuan (CNY) could compel the RBI to weaken the Rupee to maintain export competitiveness.
 

US Federal Reserve Rate Hikes: If the US Federal Reserve unexpectedly raises interest rates, it could draw investments away from India and weaken the Rupee.
 

Despite these potential risks, the overall outlook for the Rupee is positive. The Indian economy is on a stable footing, with strong foreign exchange reserves, improving financial markets, and a lower risk of recession compared to many other countries. These factors are expected to contribute to a more stable and resilient Rupee in the years to come.